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Lesser of two (or eight) evils

It was a classic advisor bake-off.

Eight one-hour slots, back-to-back, with each firm pitching hard for their role on our deal. 

The routine was always the same. Each firm rolled in with a thick deck of fluff and four or five partners to show off their credentials.

At least 90 percent of the slides were marketing nonsense, and only one of the partners at the table would actually show up if they won the work.

But this bake-off was particularly entertaining. A massive deal had shaken up our sector earlier in the year, and now every firm claimed a piece of it on their brag slide.

By the end of the day, I had heard the same story eight times. I finally called one of them out.

“There seem to be a lot of folks who led that deal. You are the eighth firm today to say so. What exactly was your role?”

“We advised one of the bidders,” came the reply.

“Which one?”

They told me. I smiled.

“I did not realize they were even in the mix. How far did they get?”

“Not far,” they admitted. “They had a look but decided not to bid. Didn’t go beyond the first round.”

“Oh, I see. That is not exactly a leading role, though, is it?”

Sure, it was an awkward moment to end on. But after hearing the same bluster all day, my patience was thin.

Selecting the right advisor for a deal is critical, whether it’s M&A or financing. But it’s no easy task when every pitch starts to sound the same. Fluff, buzzwords, and a parade of credentials only go so far.

Still… pick you must.

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The DD-Dance

In this CFO Secrets Playbook series, we have spent three weeks on the technical meat of Financial Due Diligence:

• Week 1: Introduction to FDD

• Week 2: P&L due diligence and Quality of Earnings Reviews

• Week 3: Balance sheet and the dreaded working capital peg

Now, in Week 4, we focus on managing the FDD process in the real world.

If you cannot control your advisors, your scope, and your fees, it does not matter how brilliant your analysis is. You will drown in advisory costs before you ever sign.

Time also kills deals. The seller (and their rep) will favor a faster, simpler close if all else is equal. I have personally seen the highest bidder get axed simply because their due diligence scope felt too painful.

I have made plenty of mistakes with DD exercises: overpaying, under scoping, wrong firm selection, you name it. Most of those mistakes were baked in early when we set up the engagement.

Get the FDD provider set up right, and you have already managed most of your risk.

That can be tricky, though. You need the right provider, the right team, the right scope, the right engagement structure, and the right fee structure. It is harder than it sounds.

FDD outputs can vary wildly.

An SMB Q of E might be ten tabs in a spreadsheet plus commentary, while I have seen Big 4 FDD reports that fill three volumes of 170 pages each. Know what you need and why. Then move on to how.

Here are the eight steps to setting up an FDD advisory engagement:

1. Risk assess the deal assumptions

2. Decide upon engagement structure

3. Build outline scope

4. Test scope and fees on a friendly partner

5. Send scope to shortlisted firms

6. Hold advisor bake-off

7. Negotiate fees

8. Finalize the engagement letter and appoint

Let’s take each in turn.

1. Risk assess the deal assumptions

Start by listing the key deal assumptions that drive your valuation. If any of these assumptions are off by a mile, it could derail your entire deal thesis.

The high-impact areas:

• Revenue: Robustness and repeatability of revenue

• Adjusted EBITDA and trading performance: How many adjustment lines are there? How volatile is current performance?

• Net Working Capital: How volatile is working capital? Are there any spicy accounting policies in the draft purchase agreement?

• Hidden debt or debt-like items: Might there be skeletons such as underfunded capex, litigation, or massive tax liabilities in the close? Are you buying shares or assets? Hidden liabilities are much lower risk in asset deals.

• Other platform diligence: Impacts from wider platform diligence. Think: operational, environmental, people, etc. that could move the needle on financials.

• Value drivers: Margin expansion, overhead savings, revenue synergies. Anything that - if it flops - the deal could blow up.

• Data integrity: How robust are the management data sources?

Here’s a good litmus test I like to use: play the “what if we are off by 20 percent” game. Ask yourself which assumptions, if wrong by 20%, would blow up the value equation.

These are your highest risk assumptions.

You also need to factor in who your audience is (investors, lenders, internal stakeholders, board, etc.), how much detail they will expect, and on what timeline.

Data quality is often a limiting factor in FDD. Understand these limitations upfront, so you don’t end up paying for work that can’t be performed.

2. Decide upon FDD Structure (Reliance vs. Assistance)

Once you know your major risks, decide between a Reliance and an Assistance engagement - this choice sets the tone for cost, scope, and liability.

Let’s look at both:

Reliance Engagement

Choosing reliance means the firm issues an official opinion you and your lenders can rely on. If a significant liability later emerges, you could theoretically sue them.

Think of it as the premium package. You receive a polished report on official letterhead, which carries weight with boards and lenders. It’s a thorough piece of work.

And if issues arise, you can point fingers at the advisor. 

However, this comes with a high price tag: firms demand a minimum scope akin to an audit.

A full reliance FDD report is a six-figure plus commitment. Risk-averse boards or banks will push for reliance engagements because, if things go wrong, there's someone to blame.

Assistance Engagement

Assistance is more flexible and budget-friendly. You define the scope, and they execute. There is no formal opinion or letterhead. You maintain full scope control.

If you say “only check revenue recognition,” that's all they do. This approach efficiently adds resources to your team or extra eyes to a small deal; directed to a specific scope. In the past - on low risk deals - I've use this model to second a Big 4 senior manager into my team for six weeks to help close deals.

But, buyer beware. In this type of engagement, liability rests on you. If they miss something, you cannot sue. And you will bear the brunt of the fallout if the board demands accountability for a sh*tty deal.

How to choose

Your board or lenders might decide for you. But if it’s up to you, weigh these questions:

• What would have to go catastrophically wrong for the business to regret this deal?

• How likely is that scenario?

• Do I sleep better paying for reliance, or do I trust my risk assessment?

• How much will this insurance policy cost?

If the downside sounds scary - pony up for the premium package.

Sell-side diligence

Most of the above assumes buy-side diligence.

In Europe, sellers often commission a full FDD report that buyers can rely on, giving sellers the power to shape the narrative and reduce duplicated effort later on.

This doesn’t eliminate buy-sude diligence, but it does control and manage the scope of it. Which is attractive for sellers.

In the US professional services liability caps tend to be lower - making sell side diligence less useful to buyers. So you don’t see it that often.

3. Build outline scope

Advisors love to gold-plate the scope. Big 4 partner’s second (or third) houses don’t buy themselves, you know...

Every extra hour means more fees. As CFO, you must challenge each line item and avoid scope creep.

Start with an outline scope by asking key questions:

• What time frame is in scope: current pro forma, historical actuals (how many years), future forecasts (how many years)?

• Where do you want the focus: which parts of the P&L, Balance Sheet, and Cashflow?

• Which specific risk areas require attention (revenue recognition, inventory reserves, etc.)?

• What is the timeframe for the process, and what templates or formats for key review schedules are needed?

• What outputs or reports do you require, and at what stage?

Match your scope to the M&A process. Is it a full auction with many bidding rounds? If the seller only wants indicative first-round offers, avoid heavy spending until you pass to the second round or secure exclusivity.

Organize tasks into three buckets:

• “Must do”: Critical tasks like line-by-line review of EBITDA adjustments or validating inventory

• “Do if…”: Areas to dive deeper if uncertainties or risks emerge beyond the basics

• “Do not do unless…”: Low-priority tasks that only matter under specific conditions

This should help you organize your scope into a multi-stage process, meaning that work only gets done once you are sure it is needed. This is critical for managing fees.

A good scope document spans a couple of pages and will include an outline of key financials for both the target and your business.

4. Test scope and fees on a “friendly partner”

Before going to multiple advisors, run your draft scope by a preferred or friendly partner at your [insert favorite] Big 4 firm. As long as it’s not KPMG (kidding… kind of).

Ideally, this is someone you’ve worked with before and knows your approach. You can dangle a carrot here and tell them that they have a great chance of winning the work. But you need a bit of their time to ensure you are thinking about it correctly.

They will write the time off to a ‘business development’ time code hoping to win some business, and you get some free informal advice on how reasonable and realistic your scope it. A win-win.

They can spot unrealistic expectations or tight timelines. Ask them how they would price it. If it is way off your estimate, this gives you an opportunity to revise.

Just don’t mislead your friendly partner. Or this will be the last time they help you. Make sure they know you will be putting this work out to tender, but they get ‘first look.’

Competition keeps them on their toes, and they will feel special that they were the one you asked.

5. Send scope to shortlisted firms

So, you have a sensible outline scope of work that is tested on a trusted advisor.

Now it is the formal Request For Proposal (RFP) stage.

You can turn your outline scope into a provider briefing pack (more precisely, the intern can), taking into account any feedback from your friendly partner in the previous stage.

This is the document that tells the advisory firms how you want them to pitch to you.

So be specific about format, timelines, etc.

Give each shortlisted firm the same briefing pack, so you have a level playing field. Plus, it will make the comparison process more manageable.

Picking the shortlist in itself needs some thought.

If the seller has KPMG working and your auditor is EY, that might already rule out half the Big 4 on independence ground. So it’s not always as simple as reaching out to the Big 4.

You should include at least one mid-tier firm that will give you a ‘challenger’ fee quote. Ideally more than one. This is helpful for negotiating later.

Then there are specialist boutique firms that specialize in certain industries or capital structures (i.e. there is a whole world of advisory firms that specialize in PE-backed and leverage finance situations.) These can be a good choice for higher risk deals (but are often more expensive than the Big 4).

One note of caution. The more widely your RFP gets distributed, the greater the risk that the process leaks. This world is small. Big 4 partners, lawyers, investment bankers, etc., talk to each other (probably over martinis).

I am always stunned by how fast word gets around when there are fees up for grabs.

6. Hold bake off

Your shortlisted firms should all be invited to a ‘bake-off.’ Each firm should be allocated a 45-60 minute slot. Allowing for 15–30 minutes between slots to avoid crossover and awkward corridor moments.

Invite them to present. They will show you their plan, their team, fee proposals, and their credentials. Let them battle it out.

Make sure you have space in your bag. You are going to take home 4-8 x 100-page decks (even though you asked for a max of 20 pages).

More important than the slides is testing for chemistry. Your team will work closely with theirs under stress, so ensure you actually like working with them. I once worked with a brilliant but overwhelmingly intense (and aggressive) M&A lawyer. After a few deals, I realized I needed someone equally effective but less unpleasant. Just for my own sanity.

Also, verify that the team you meet will actually do the work. The oldest trick in the Big 4 book is the bait-and-switch. You meet the stars at the start, only to never see them again.

Finally, understand their relevant transactions. Recent relevant transaction experience (and industry experience) is extremely valuable.

The hard bit is that all will claim to have it. And will also claim the ‘tombstones’ from previous relevant deals. Just make sure you know exactly what their role was (as you saw in the opening anecdote).

7. Negotiate

Once you have the proposals, it’s time to analyze them side-by-side in a simple comparison table.

Comparability on fees can be tricky, especially when scopes differ, so ensure you compare like with like. Avoid being led solely by fees. While overpaying is undesirable, final costs often only emerge after months of scope refinement. Focus on securing the right firm at the best possible price.

I narrow my choices to two firms for detailed negotiations, as stringing along too many firms at once is impractical. This is the time to examine fee details: the build-up of the quote, staff involved, hourly rates, and applied discounts.

Avoid fixed fees for complex engagements due to uncertainty in pricing. I prefer time-and-hour arrangements with caps, fee stops, and escalating discounts. For instance, negotiating an X% discount on the listed hourly rates, but X increases as the number of hours spent on the engagement increases.

It’s a nice way to align incentives on efficiency.

Consider incentives: encourage efficiency and include ‘kill fees’—discounts if the deal dies.

I often have my Head of Corp Dev conduct the first negotiations to extract maximum value. Leaving room for me to go back in for round 2, and occasionally even the CEO for a final go if I think there is more to be had.

When finalizing, I always have a ‘whites of their eyes’ conversation with the partner. I say, “This is a very important transaction. I’m trusting you with it. If things go wrong, call me personally about any fee deviations. I want a one-on-one weekly call to confirm there are no nasty surprises.”

That top down commitment will be valuable later.

Fee and scope creep is like water – it seeps into gaps you didn’t know existed. Don’t give it any room.

8. Finalize Engagement Letter

You have the key points nailed down. Now it's time to formalize them in the engagement letter.

Best to get a lawyer's help if you can here to make sure all the nuance has been caught.

This is your contract. So if it is vague, expect expensive surprises later:

• Scope, fee, Senior Partner: Write it all down. If disclaimers are buried, call them out.

• Fee structure: Whatever fee structure you have agreed, make sure it is robustly documented

• Team composition: If you are paying $750-$1,500 an hour, you deserve more than interns. Make them confirm in writing who is actually on the job.

• Liabilities and indemnities: Have your in-house lawyer check how they cap liability

• Deliverable format: Make sure you are clear on what the actual output format is

The engagement itself

You might think I’ve over-labored the process of setting up the engagement. After all, the real work doesn’t start until the engagement letter is signed.

But honestly, all the disasters I’ve seen can be traced upstream to poor alignment and expectations in the engagement setting process.

Get this right, resource it properly, and communicate well, and you’ll set yourself up for success (or at least less painful failure).

Wider Diligence

You will remember at the start of this series we saw that FDD is just one component of total platform diligence.

But the process above can be adapted for pretty much any advisor appointment. Finance, legal, consulting, etc. M&A, tax, advisory, financing, etc.

Net Net (Wrapping Up the FDD Series)

And that’s our four-week odyssey through the world of Financial Due Diligence.

From sniffing out real earnings and taming the balance sheet to playing chess with working capital, and finally, keeping your advisors (and fees) in check.

The moral of the story?

A well-run process will save you from nasty surprises and give you leverage in negotiations. A messy one will cost you time, money, and your reputation with the board.

And financial due diligence is the cornerstone of that process.

But FDD can’t exist on its own. It is just one piece (an important one, but only one) in an M&A deal. So make sure you always keep the perspective of the total deal when running an FDD process. It’s easy to lose sight in the heat of the deal.

That’s it for our FDD Series. Next up, a series on the future CFO.

PS - if you need a reliable provider for quality of earnings reviews for SMB deals - just hit reply and I will personally introduce you to someone I trust.

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