Vendor Due Diligence

What is a vendor due diligence?

Vendor due diligence (seller-side due diligence, VDD for short) is a review of the company being sold, which the seller commissions from independent reviewers before the sale process. The results are set out in reports (vendor due diligence reports), which the prospective buyers receive. These reports shorten the interested parties' own review (due diligence), but do not make it unnecessary. The difference lies in who commissions it: the usual due diligence is commissioned by the buyer, the vendor due diligence by the seller.

The vendor due diligence belongs to the company sale, above all to the structured auction process with several interested parties. It is common in sales by financial investors, in the carve-out of business units and in mid-sized sales with several bidders. The review is carried out for finance and tax usually by audit firms, for legal topics by law firms. The reports are placed in the data room; their contractual effect is regulated in the purchase agreement.

Benefits of vendor due diligence in the auction process

Without vendor due diligence, every bidder reviews for itself. Management answers the same questions several times, the timetable depends on the slowest interested party, and the offers rest on different assumptions. A joint report changes this in several respects:

• Comparable offers: All bidders calculate on the same basis for earnings adjusted for one-off effects, net debt (financial debt less freely available liquid funds) and working capital (capital tied up in day-to-day business). Differences between the offers then reflect the assessment of the business and not diverging methods of calculation.
• Speed: Bidders can submit a robust offer earlier. Their own review is limited to open points and those that are especially relevant to them.
• Relief for management: Questions are answered once to the seller's reviewers instead of in parallel to several teams.
• Early knowledge of weaknesses: The seller learns before the start of the process what a buyer would find. The seller can remedy defects, prepare explanations and build its disclosure schedule (the list of exceptions to its warranties) on this.
• Setting the narrative: The report is the first to classify matters, and it does so through an independent reviewer. This presentation becomes the starting point of the negotiation.

Outside the auction process, the benefit is smaller. If a seller negotiates only with one interested party that reviews comprehensively anyway, a full vendor due diligence often causes double costs. In funding rounds it is rare; there a careful preliminary review of one's own is usually enough.

Scope and report formats

The scope follows the risks of the business. The core is almost always the financial vendor due diligence with an analysis of earnings quality, net debt and working capital. A databook with the prepared financial figures is often part of it. Depending on the business model, tax, legal, market, technical or environmental topics are added. Three forms are to be distinguished:

• Review report with assessment: The reviewers describe matters, assess risks and are prepared to stand behind the report to a limited extent towards the later buyer (see reliance letter).
• Descriptive report (fact book): common above all in the legal area. It presents corporate relationships, material contracts and intellectual property rights without assessing them.
• Vendor assistance: Advisers prepare documents and figures without producing a review report of their own. This is cheaper, but offers the buyer no basis on which it can rely.

Reliance letter and liability of the reviewer

The reviewer works on behalf of the seller. A buyer may therefore rely on the report only if the reviewer expressly allows it. This is done in a reliance letter. As a rule, only the successful bidder receives it on signing of the purchase agreement (signing), often together with its financing banks. The reviewer's liability is capped in amount and tied to the state of the report.

In the earlier phases, interested parties receive the report only against a declaration (non-reliance letter or release letter). In it they confirm that they do not rely on the report, and waive claims against the reviewer. This declaration comes alongside the confidentiality agreement (NDA) that every interested party signs before access to the data room.

Relationship to the purchase agreement and warranties

The vendor due diligence does not relieve the seller of its liability under the purchase agreement. For the correctness of the report itself, the seller generally gives no warranty; what remains decisive are its warranties about the company. Whether the content of the reports counts as disclosed against these warranties is a regular point of negotiation. Sellers want to include the reports in the disclosure schedule; buyers often accept that only for specifically described matters.

In addition there is the question of knowledge. What is in the report is known to the buyer. Whether this knowledge excludes its later claims is decided by the knowledge clause of the purchase agreement. Buyers therefore often demand that only specifically disclosed circumstances affect their claims.

For warranty insurance (W&I insurance), which covers the buyer's claims for breaches of warranty, the reports together with the buyer's supplementary review form an important basis. Risks that are expressly named there are generally excluded from cover by the insurer.

Practical example: vendor due diligence for an IT service provider

An IT service provider with revenue of EUR 25 million is to be sold in an auction process. Four months before the start of the process, the seller commissions a financial and tax vendor due diligence and a legal fact book. After the approach, nine interested parties sign a confidentiality agreement.

• The financial review shows working capital that fluctuates strongly with the season. The report derives a reference value from the average of the last twelve months, which all bidders adopt.
• The tax review finds an incorrect VAT treatment of services to customers abroad. The seller has it corrected before the start of the process and discloses the matter.
• The fact book shows that two freelance developers never granted the company rights of use. The contracts are supplemented before the data room is opened.

Five interested parties submit an indicative offer on the basis of the summary, three receive the full report. The selected buyer limits its own review to three weeks with a focus on technology and sales and receives the reviewers' reliance letter on signing.

The vendor due diligence works twice over here. The two remediable defects no longer appear as findings in any buyer review, and all offers rest on the same reference value for working capital. Differences between the offers thus show how the bidders assess the business, and not how they calculate.

Distinction: vendor due diligence, buyer review and red flag report

• Buyer's due diligence: commissioned by the buyer and tailored to its questions. After a vendor due diligence, it often shrinks to a confirmatory review.
• Red flag report: a report only on material findings. A seller can use it as an internal preliminary review, whereas the vendor due diligence is intended to be passed on to bidders.
• Financial health check: an internal stocktake of the financial position and finance function for the company's own management. It often clarifies in advance whether a vendor due diligence is worthwhile, and is not passed on to bidders.
• Supplier review: In purchasing and compliance, the review of suppliers and service providers is also called vendor due diligence, usually by means of a questionnaire (vendor questionnaire). This meaning has nothing to do with the company sale.

Common mistakes

• Report without findings. A report that contains no weaknesses looks commissioned to please. Buyers then review all the more thoroughly themselves, and the time advantage is lost.
• Scope too narrow. Anyone who has only the finances reviewed leaves the legal topics to the buyer, although the most costly findings are often found there, for example rights in software or termination rights on a change of control.
• Outdated reporting date. If the figures at signing date back many months, buyers demand an update to more recent monthly figures or calculate with assumptions of their own.
• No alignment with plan and presentation. If the figures in the report deviate from the financial model and the management presentation, this calls the seller's entire presentation into question.
• Reliance not regulated in advance. Without an agreed reliance letter, the buyer reviews everything itself after all, and the costs of the vendor due diligence achieve little.
• Findings without follow-up measures. A recognised defect that is neither remedied nor explained by the time of the buyer's review loses its value as early information.

Frequently asked questions

Does a vendor due diligence replace the buyer's review?

No. Professional buyers verify the points most important to them themselves, if only because the report was produced on behalf of the seller. The scope of their own review falls, however, often to a confirmatory review over a few weeks.

Who pays for the vendor due diligence?

The seller. Occasionally the purchase agreement provides that the buyer bears the costs in whole or in part. That is a matter of negotiation and rather the exception.

Do all interested parties receive the full report?

As a rule not. Tiered access is usual: all admitted interested parties receive a summary after the confidentiality agreement and non-reliance letter, the full report only the bidders on the shortlist.

When is the vendor due diligence commissioned?

Often two to four months before the planned start of the process. That leaves time to remedy findings, and the figures are still current when the offers arrive.

Can the buyer claim against the reviewer for errors in the report?

Only if a reliance letter has been issued to it, and then to the extent agreed there up to the agreed liability limit. Claims against the seller are governed by the warranties in the purchase agreement.

The Roemer Capital view

Whether a vendor due diligence is worthwhile, we decide with the client at the start of preparing a sale, which typically takes 6 to 12 months. The deciding factors are the expected number of bidders, known weaknesses and how much review effort management can carry alongside the ongoing business. If a review is commissioned, we agree the scope with the reviewers chosen by the client and set the reporting date so that the figures are current when the offers arrive.

The reports are prepared by auditors and law firms, not by us. We make sure that adjusted earnings, working capital and net debt agree in the report, in the financial model and in the management presentation. We also prepare the seller for the follow-up questions that the report will trigger among the bidders.