The Importance of Due Diligence in Acquisitions and Mergers

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Dear CFO,
Management is currently targeting an acquisition and I’ve been told I will be in charge of the project plan for the acquisition due diligence and subsequent integration of the business. This is a new experience for me and I am not sure where to start.
Finance Manager in St. Louis

It is wise to seek help during the acquisition process. The good news in your question is that management is just targeting an acquisition. Since seeking an acquisition is often a very confidential process, gathering data and setting up the plan as a “preparation for a potential acquisition” is a good cover. This gives you time to actually plan and seek input from the various departments within your organization before the acquisition takes place. Often times the acquisition due diligence and integration are an afterthought of the “hunt.

Keep in mind, participation in acquisition due diligence is often quite limited due to the confidentiality involved in seeking and evaluating an acquisition target. Make sure your CEO or Corporate Development Team clearly defines who can and will be involved in the process. Often outside firms are used during the due diligence process to avoid rumors of the sale disrupting current operations of either business. If your CEO clearly defined the “why” and the “what” of the acquisition, the focus of the acquisition due diligence is clearer.

Acquisition Due Diligence

The main objective in due diligence in acquisitions and mergers is the verification of the thesis for the acquisition. Typically, the objective of acquisition due diligence is verifying the business representations of the seller (financial results, market penetration, customer satisfaction and continuity, vendor availability, production/service capability, distribution channels) as well as identify “skeletons in the closet” (outstanding warranties, lawsuits, insurance issues, customer concentrations, vendor reliance, a new product by a competitor, or unfavorable contract clauses, to name a few).

The results of due diligence in acquisitions and mergers may reframe the negotiations or actually kill the deal. If the Letter of Intent (LOI) is well written and there is a joint vision, surprises in due diligence can often be overcome without killing the deal. This is why strategic planning is so important. Involve your outside legal and business advisors to create a comprehensive acquisition due diligence plan. Experienced advisors will point out gaps in your process and provide tips on specific areas needing attention. You know a lot about your business, so use that knowledge and that of your advisors to form a comprehensive framework, including pertinent tips below.

Due diligence in acquisitions and mergers often starts with the analysis of the historical financial statements and forecasts. In a larger company with audited financials and full footnotes, you can place more reliance on the historical statements themselves. There are additional procedures for all financial due diligence. In a smaller company with internally prepared or reviewed statements, I would suggest additional financial due diligence.

Acquisition Due Diligence Procedures

  • Verify that each account on the balance sheet is reconciled, preferably monthly, and review the reconciliations for unusual items, just as you would with your own company’s balance sheet. If allowed, confirm customer balances and aging, and engage in discussions with vendors on payment history.
  • Validate revenue through cash. In a spin-out from a larger organization, the seller represented sales at a level that I could not trace through to cash. So, in my opinion, sales were overstated. As a result, a $1 million look back provision held money in escrow that we claimed when sales did not match the represented amounts.
  • Determine policies and procedures are in place to assure control, completeness, and accuracy of financial information. If these do not exist, focus more procedures on the forecasts and financials to verify the information.
  • Identify the qualifications of the individuals contributing to the financials and evaluate the general level of competence of the staff.
  • Identify activity on the financial records that might lead to other disclosures: legal expenses, rent, or outside services might identify or help quantify risk/exposure areas.
  • Verify all expenses were included in the financials. Often financials of closely held companies are adjusted for the “extras” that the owner took out of the business; be sure that your company will not incur similar expenses. Watch another area of adjustment: the removal of “one-time” expenses (often with further discussion, they are not one-time).
  • Observe service/production and inventory areas for general organization and busyness, paying attention to the workforce and physical characteristics. Pay attention to potential obsolete and unused equipment, work areas, and inventory. Observe the quality and quantity of any finished goods not shipped. A previous client of mine once had significant consigned inventory on-site from both vendors and customers (billed but not shipped). Ask questions to make sure what is on-site belongs to the company and is in use. Often a complete inventory observation is a condition of the sale. Verify that assets on the asset list are physically present and in use.
  • Analyze any forecasts and assumptions thereof with a critical eye in the context of:
    • Historical performance and relationships – if the company claims a new product will bump sales by X%, what is the basis of the claim and have they achieved similar success in the past? How have supporting costs moved in a similar direction? What is the basis of the cost relationships?
    • Assumptions in the forecast related to the balance sheet make sense. If they are at 80% capacity and increasing sales will exceed capacity, how will they meet the need, expansion, or outsourcing? Is that properly reflected in the numbers?
    • Changes in divisional or product line expectations, especially if they are inconsistent with past performance.
    • Are balance sheet assumptions consistent? If they are going to improve collections to reduce days sales outstanding in receivables, is the strategy plausible and are any associated costs also projected? Will they need more inventory if a new product line is added and have they forecasted that?
    • Ask more questions on anything represented in the business plan that has a financial impact. Clarify both the thought process in the conversion to the forecast as well as the actual inclusion in the forecast.
    • Look for all elements of the business plan (private placement memorandum or another document) consistently represented in the financial statements and forecasts.

Generally, during due diligence in acquisitions and mergers, a buyer will also run their own forecasts using both the seller’s assumptions and adding their own, such as economies of scale, consolidation of positions, etc. Even if the seller recognizes that you will be gaining additional benefit, most buyers try not to pay for what they bring to the table. Keep in mind, although this is conventional wisdom and a laudable goal, in competitive bid processes, buyers are often paying for synergy they bring

Verifications During Due Diligence

Even though the numbers are a significant driver of the pricing in the sale, other factors also influence pricing including representations and “skeletons.”  In a small company, much of the acquisition due diligence falls under the umbrella of the financial area, so you may be called upon to verify items outside of the financial statements. Thorough analysis of the financials may reveal skeletons and verify representations, however addressing other financial issues often requires independent verification of representations.

Some areas of verification during the acquisition due diligence process are:

  • Customers – To determine satisfaction, look for online reviews, analyze customer retention, or send a survey or other independent means of verifying satisfaction. Customer contracts giving special pricing or long-term commitments with customers should also be factored into your analysis.
  • Market penetration and position – Contact an industry trade organization and seek government or industry reports on the size of the market and new developments in the industry. Compare these reports with the seller’s representation and actual position. Look for new products that are competing within the market. Pay attention to the cliché here – Did buggy whip manufacturers see the end of the market with the introduction of the “horseless” carriage? Think broadly. Remember, only Steve Jobs saw the “need” for the iPhone.
  • Vendors – Determine if the primary raw materials of the seller (ex. people, steel, plastic, or other material critical to the process) are readily available and obtainable through multiple vendors. Also, contracts and purchasing agreements both length and availability affecting the cost of materials come under scrutiny.
  • Employees/Culture – com reviews, compensation and benefits packages, tenure, discipline actions, interviews, and observation of the work areas can all help frame the culture of the organization and the ability to fit with yours. In a large company where I consulted, there were bells to tell people to take breaks, eat lunch, etc. This culture may not bring employees fit for an entrepreneurial environment, or people with narrowly focused or previously micro-managed jobs may not fit an “all hands on deck” atmosphere, as I learned in my organization. In my opinion, we pay too little attention here and it often is the make or break piece of the deal.
  • Contracts – Have your legal team review important leases, software, and other licensing, purchasing, or sales agreements, distributor agreements, insurance, and any other agreements that may influence how you move forward.
  • “Skeletons” – Review legal bills to identify issues, insurance clauses for coverage of product liability, PR faux pas, OSHA reporting, and other inside and outside reporting or contracts for hidden risk areas. Evaluate company performance under various economic conditions. Are they the first to see the impact of a downturn or among the last, and where are they in the cycle now?

Some or all of these factors may or may not be important to examine during the acquisition due diligence. It really depends on the “why” and “what” behind the acquisition, as well as the form of transaction (stock purchase vs. asset purchase), if the company is looking at the acquisition for the short or long-run, if you need it to fill a missing part of your product offering, and so on. Look at all the factors that play a role in the acquisition. Planning your due diligence should focus on what you are seeking to gain in the transaction, but not to the exclusion of evidence to the contrary in moving ahead. Don’t fall in love with the process or the target.

I believe acquisition due diligence should be performed with skepticism. Identify the risk/benefit areas of the acquisition with an objective view and present the findings for deliberation in the negotiations and pricing steps of the deal.

After the acquisition due diligence comes addressing the integrations. For these steps and more important tips to help you succeed in your business, find more on CEO Buddy!

Feature image via Pxhere. All post images licensed for use via Pxhere licensing.

About Author

about author

Lynne Robinson

Lynne brings years of experience in service industries, manufacturing, leasing and corporate finance. She started CEO Buddy to help small business owners grow their businesses.

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