Conducting sell-side due diligence helps increase the likelihood of a business sale’s success. Performed correctly, the process uncovers opportunities for sellers to enhance their company’s value prior to a sale and facilitate a faster close time.

In the restaurant industry, where there’s a strong level of M&A activity and intense competition for growth, companies contemplating a sale can often advance their strategic goals by leveraging sell-side due diligence.

Here are the answers to important questions sellers face prior to and during the process.

Benefits

Among its benefits, sell-side due diligence can help business owners identify and assess issues and trends that either positively or negatively impact business value from a buyer’s perspective. This helps owners gain early, vital insight, which can help establish a strategic framework for selling a company later on.

Put Your Best Foot Forward

Backed by due diligence findings, sellers can project greater confidence in their position, helping to bolster a buyer’s perception of the company. This can help a business owner avoid major surprises or gaps in expectations that could delay or kill a deal. There are also generally fewer unforeseen costs and added professional or consulting fees, which can result from a lesser degree of preparation.

Enhance Deal Value

Insight gained through this process can help sellers proactively manage the way they explain financial results, accounting policies, processes, and other aspects of the business during negotiations. It can also allow them to better anticipate buyers’ questions—keeping the discussion focused on the strategic basis for the transaction. Analysis performed during due diligence can reveal critical deal points or transaction structures that could help increase deal value and after-tax proceeds.

Manage Workflow

The demands placed on a company’s internal resources to support a transaction can be intense, and senior management is usually hit hardest as they struggle to balance go-to-market preparations with maintaining successful operations. Sell-side due diligence helps avoid excessive demands on management’s time and eases the potential disruption of buyer requests. It also helps a seller proactively manage the stress of a future transaction—providing early access to company information a buyer might request. 

Address Industry Trends

Sell-side due diligence can help an organization proactively manage and prepare for questions around factors, such as:

Commodity and Labor Costs

Commodity prices are constantly fluctuating, and labor costs are subject to increasing pressure. Being able to explain the impact of fluctuating costs for materials, labor, and overhead on gross margin is critical during the sales process.

Pricing and Average Revenue

Management also needs to demonstrate its ability to maintain a strong relationship with customers and an understanding of key dynamics. This includes knowing changing trends—such as customer demand, online versus in-person orders, and ordering food to go versus dining in—and explaining how trends can impact the company’s sales.

Normalized EBITDA

Debt leverage is often used to fund transactions. Given the restaurants carry very few assets required to support senior secured debt, normalized earnings before interest, taxes, depreciation, and amortization (EBITDA) is increasingly crucial to supporting buyer valuations and acquisition debt models. Surprise adjustments are even more problematic in these scenarios.

Paying More for a Good Reputation

Buyers are generally willing to pay more for companies with good brand reputation and recognition. The extent to which a seller is prepared to tangibly demonstrate these attributes can help to enhance buyer perceptions exponentially.

Legacy Brand Acquisitions

Large operators seeking growth are often interested in acquiring emerging concepts rather than developing them internally. During the sale process, these buyers’ demands and information expectations can be more rigorous than those of the average buyer.

Prepare for a Sale

It’s important to perform and present sell-side due diligence in a way that’s consistent with how experienced buyers will consider the transaction. That means it’s key to prepare adequately and have a full understanding of industry-specific practices relevant to assessing current and future earnings, accounting policies, and trends.

Realistically, preparing for a sale—including conducting sell-side due diligence—should begin six-to-twelve months prior to the anticipated market date. This allows enough time for the seller to organize financial information and prepare management for a potential buyer’s due diligence process.

It also provides the seller enough time to adequately position the company for sale—preparing multiple years of performance data, implementing systems and information that will be desirable to potential buyers, and calling in backup, if necessary.

Preparing in this way can help sellers align their accounting, finance functions, and reported results with standard industry formats. It can also help them navigate the process more efficiently and enable them to focus on key areas—compiling data from multiple locations and increasing productivity.

Common Gaps and Weaknesses

Without adequate preparation, companies in the restaurant industry often fall short in a few common areas.

• Store-level operating metrics. Performance metrics, such as labor and overhead costs, can be essential as a company goes to market—and a buyer will invariably look at them closely. However, many companies in the restaurant industry aren’t proficient at properly tracking these metrics.
• Vendor rebates. Many restaurant chains have rebate agreements with beverage or food vendors that aren’t properly accounted for under GAAP.
• Lease accounting and other issues. Many sellers don’t adequately maintain GAAP accounting, including proper treatment and summaries of all lease incentives, expiration dates, and renewal options.
• Store pre-opening and build-out costs. In growth concepts, these costs may not be tracked separately, diluting reported earnings before EBITDA for the current period, rather than reflecting the recurring cost of operations.
• Franchise and regional development fees. Revenue and expense recognition for these fees is often accounted for on a cash basis by franchisors or franchisees.
• Special franchisee or franchisor agreements. Franchisees may have received certain incentives through lower royalty or marketing fee rates for being an early-stage franchisee that terminate on change of ownership. It’s important to consider the impact of these conditions.
• Run-rate analysis. In multi-unit concepts, it’s common for business owners to open, close, renovate, or move a company, resulting in data that doesn’t reflect the true value of location’s annualized earning potential. Sellers often don’t have an analysis of the impacts this process has on their business.
• Sales and use tax, payroll tax, and tip reporting. Many sellers aren’t prepared for the level of scrutiny a buyer may apply to the transaction in order to avoid potential successor liability issues.
• Carve-out issues. Multiconcept, region, or location operators may sell only a portion of their locations, distributing additional locations to a management company. Certain costs or other income accounted for at the management company level may not be properly allocated to the individual locations.

Address Deficiencies

Deficiencies found during sell-side due diligence can and should be mitigated. It’s important to note, though, that when it comes to changing policies, reporting, or processes, the closer companies are to a planned transaction, the more difficult it becomes for buyers to assess what’s normal or the impact of those changes.

If possible, sellers should avoid making changes to significant accounting policies and financial reporting systems within a year or two of a sale. Having consistent information makes it easier for buyers to assess the merits of a transaction.  

To the extent deficiencies are found, pro forma adjustments can be made during sell-side due diligence to account for these items, rather than changing the underlying data in the system. Even if a company decides not to sell, taking the time to analyze and address deficiencies can help stakeholders improve the organization’s profitability and performance.

We’re Here to Help

Sell-side due diligence is typically performed by certified public accountants. The reports provide credible financial information—such as potential adjustments to earnings—that investment banks rely on and include in an offering memorandum. Accountants also help management prepare to explain financial information to potential buyers, providing information in terms consistent with standard accounting practices.

If you’d like to learn more about how sell-side due diligence could benefit you and your organization, contact your Moss Adams professional.