This article was updated December 2020.
Due diligence is a critical component of every investment, whether your company is seeking a new round of venture funding, pursuing a private equity cash infusion, or positioning itself for an acquisition by a strategic or financial buyer. But the metrics each investor deems critical varies—and might not align with what a business initially considers its primary strengths or successes.
Knowing what you’ll face when due diligence begins—and preparing effectively—can help a company position itself for better negotiations, higher valuations, and stronger outcomes.
In this article, we’ll address four key ways businesses can prepare for due diligence and more clearly demonstrate business value to secure a better deal. But first, let’s address why it’s important to begin positioning for the due diligence process early.
Understand an Investor’s Perspective
Consider a start-up software company that’s focused on signing up new customers and that signs a $5 million deal with a major corporate partner.
On paper, the deal is a major milestone that builds the company’s momentum and generates excitement from the workforce. And while adding bookings will initially impress early-stage investors, the deal’s structure determines how valuable the company is later, when it’s time to raise institutional capital from financial or strategic investors.
Late-stage investors are looking for more than early wins, no matter how big the wins are. They want stability and growth in annual recurring revenues (ARR)—proof that management can retain customers, scale operations efficiently, and ultimately run a profitable business.
During due diligence, a potential buyer will turn over every stone to assess a business’s past and predict their investment’s future growth. Bookings of $5 million or more might look good to a venture capital (VC) or private equity firm taking a minority stake in an early-stage growth play, but it might not be as impressive to a buyout or majority investor that cares more about sustained growth, scalability, and profit under US Generally Accepted Account Principles (GAAP).
The reality is that a company that’s positioning itself for a sale or major investment may need to provide a potential investor with up to three years of audited financials to get through the due diligence process. This means management needs to act like the company is continuously undergoing due diligence—from the time it first starts doing business to the time of the deal.
Here are four strategies to better prepare for due diligence and secure the deal you want.
Invest in Professional Accounting Practices
While bookings are important, they can’t secure financing without being converted to GAAP accounting—the universally accepted measure of comparing apples to apples, assessing true value, and revealing a company’s true worth. While VCs and minority private equity buyers may be comfortable with bookings, they’re more comfortable with GAAP, and the majority of strategic buyers will demand nothing less.
While managing two measures of revenue—bookings and GAAP—is a balancing act, the smart company will do both, knowing that the more modification and adjustment to accounting it does, the weaker its negotiating position and valuation will be when it comes time for actual due diligence. Ideally, a company beyond the seed round should be closing its books in GAAP at least quarterly and preparing two-to-three years of audited accounts.
Commit to Comprehensive Contract Reviews
When it comes to valuations, the devil’s in the details—and there’s no better place for devils to hide than in contracts made in haste. The aforementioned $5 million contract may include stipulations for comprehensive licenses or maintenance requirements that stretch a company’s resources thin when unanticipated events, such as the following, occur:
- A customer goes through a major growth phase
- The value of a company’s technology assets is diluted by rights-to-source code or other intellectual property
- Payment terms lead to unevenness in revenue
A detailed review of all business and legal contracts—along with efforts to smooth revenue streams during the negotiation phase—can go a long way toward reducing volatility that can impact what a buyer wants to pay.
Negotiate the Terms
Management shouldn’t be afraid to negotiate terms in standard contracts provided by large customers or vendors. Often, simply explaining to the other party the reasons why you require certain terms is enough to get modification. If a company is far enough along in contracting to negotiate terms, it’s an indication that your customer needs your product, and you have more leverage than you think.
If issues that don’t have easy solutions arise through contract reviews, the seller should discuss the issues with their sell-side advisors, identify them when getting ready for diligence, and disclose them to the investor up front so they can’t be used to negotiate against the seller and reduce valuation in diligence.
Manage Your Cap Tables
Every company starts somewhere, which often means friends and family who participated in a business’s early seed rounds tend to stick around. For the buyer, those early investors can become a barrier, and may need to be bought out or replaced to align the company with key business contributors and help it continue to build value.
For example, a technology company that’s positioning itself for a major investment needs to regularly re-align the cap table to reflect the key assets of the business: its employees. Before making a deal, potential investors want to know that key employees will stay with the company and parties who aren’t adding value won’t get in the way.
This means it’s important to properly incentivize key employees by giving them financial reasons to stay, and buy out noncritical parties throughout the company’s lifecycle. Operating in this way keeps your cap tables clean and valuable to the investor.
Balance Ambition with Realism
Along with running the company, the early-stage technology CEO typically does double duty as the chief sales officer—attracting new customers, negotiating contracts, and building the momentum that early investors want to see. While many companies have a CFO to handle the details of financial matters and due diligence, a CEO often takes on some of the CFO’s tasks as well.
Because of his or her central role in the business, it’s important for the CEO to build financial acumen between his or herself and the entire leadership team—especially those in business development who focus on doing deals. The CEO can then help leadership understand what to expect during due diligence, explaining how contracts they’re currently signing might help or hinder that effort. This process can help prevent the need for a major financial overhaul when an investment or acquisition is approaching.
Quality of Earning Reports
During due diligence, many investors will ask for sell-side quality of earning (QOE) reports in addition to requesting ongoing audits. When preparing the report, a company will undergo full due diligence, similar to the process performed by the buyer. This process will help management analyze potential weaknesses and clean up historical books and records, receiving assistance from professionals who can advise on best practices and help prepare the company for negotiations.
We’re Here to Help
Due diligence is a complex process that digs deep into every part of a business. No amount of preparation can replace the intensive accounting, compliance, and forensic expertise that needs to be deployed once it’s under way.
But there are steps every company can take early and often to help them get a head start—and doing so will help them position for better negotiations, higher valuations, and stronger outcomes.
To learn more about how preparing for due diligence could help your company, contact a Moss Adams professional.