Vendor Due Diligence Reports: Reducing Transaction Costs Through Seller-Controlled Diligence

March 6, 2015

Due diligence for a prospective merger or acquisition typically involves the buyer’s review of documents provided by the seller and interviews with the target company’s management. However, many sellers − particularly private equity sellers and those running auctions − now consider providing vendor due diligence reports (VDDRs) to potential buyers. VDDRs potentially allow the seller to speed up the sale process and maintain greater control over diligence. Vendor due diligence has gained popularity in many European jurisdictions over the past decade, and it is also now considered for certain mergers and acquisitions in the United States.

The Vendor Due Diligence Process

As part of vendor due diligence, a seller and its advisors will review relevant documentation of the target company and prepare a draft VDDR. Potential buyers usually are required to sign a letter agreeing that they are not entitled to rely on the VDDR until the completion of the sale process. After potential buyers review the draft VDDR, the seller usually allows them to review the underlying documentation and conduct confirmatory due diligence, which may or may not include management interviews. A potential buyer also may be permitted to conduct limited follow-up diligence on items that are not adequately covered in the VDDR. At the completion of the sale process, the successful buyer receives a copy of the final VDDR and is entitled to rely on it, subject to terms and limitations (such as caps on liability) that are included in the VDDR or the purchase agreement.

Potential Advantages of VDDRs

VDDRs are used most often in auctions and other situations involving large numbers of potential buyers. The burden on a seller can be significantly reduced when it provides a single draft VDDR to interested parties, rather than responding individually to diligence requests from multiple potential buyers. Furthermore, because only one set of financial and tax advisors conducts management interviews, the target company’s management often spends less time distracted from running day-to-day operations of the business during the sale process (although potential buyers may conduct limited management interviews as part of confirmatory due diligence). Finally, with the increased prevalence of reps and warranty insurance, VDDRs can contribute to the efficiency of an auction process with a “stapled insurance package,” removing another potential gap in negotiations between buyers and sellers.

Vendor due diligence also forces a seller to identify and mitigate potential issues with the target company before it is actually offered for sale, which sellers are always encouraged to do. If a draft VDDR fully discloses all known material risks and liabilities of the target company, it becomes more difficult for a potential bidder to submit a high initial bid to secure exclusivity and later attempt to negotiate a lower price based on problems discovered during diligence. Notably, the increased costs of early diligence may be partially offset by the seller’s ability to rely on the draft VDDR in preparing its disclosure schedules to the purchase agreement.

The benefits of vendor due diligence are not limited to the seller. Vendor due diligence also reduces the time and costs required for a potential buyer to gain a reasonable familiarity with the target company. This advantage can result in more potential buyers staying involved in the sale process for a longer period of time, which in turn may result in a higher purchase price or better sale terms for the seller. Vendor due diligence often is viewed favorably by potential lenders, who may regard vendor due diligence as providing additional comfort above and beyond that undertaken on the buy side.

Potential Disadvantages of VDDRs

In order to prepare a draft VDDR, a seller must incur the costs of hiring legal, accounting and other advisors. These costs may be significant if the seller intends for the VDDR to provide a fairly comprehensive overview of the target company. If, however, the VDDR provides only a cursory overview of the target company, potential buyers may demand additional due diligence to investigate issues that were not adequately addressed in the VDDR. A buyer also may demand significant confirmatory due diligence from its own independent advisors, even though the seller has provided a VDDR. Furthermore, although vendor due diligence may speed up the sale process after interest has been solicited from potential buyers, the involvement of management in vendor due diligence before potential buyers are solicited actually may increase the total length of time that management is exposed to the distraction and uncertainty of the sale process.