White Paper: Starting Acquisition Due Diligence Off on the Right Foot

Good due diligence begins even before an acquisition prospect is identified. The buyer should determine beforehand which characteristics are desirable and which are undesirable. A modest amount of early planning can often streamline the search process by allowing management to expediently eliminate from consideration companies that will not further the goals of the acquirer.

The objective of due diligence is straightforward and simple. The acquirer is interested in minimizing its exposure to the many problems and pitfalls that can arise when making an acquisition. The due diligence process itself is decidedly less simple. The acquirer must begin with clear and explicit expectations of the benefits it hopes to gain by making the acquisition. Only by clearly understanding these expected benefits at the outset can the appropriate due diligence procedures be identified and efficiently carried out.

Goals of “increased sales” or “improved profitability” are only part of the picture. An acquisition itself will not improve profitability. Only the well-executed combining of complementary corporate resources (or dumb luck) will create value for the acquirer. The attractiveness of an acquisition should be measured by the expected return on the investment (ROI). If the expected ROI of the acquisition is (1) sufficiently high to justify the effort and (2) equal to or higher than the expected ROI associated with internal growth, the acquisition has the potential to be a good one.

Benefits typically sought by acquirers include one or all of the following:

• A stronger market share in a key geographic region,
• The introduction of a new product into an established distribution line,
• Improved economies of scale, such as improved purchasing power as a result of larger economic order quantities or advertising costs spread over a higher volume of products or services, and
• A cost-effective way to expand the company’s production capacity.

Assessing the Attractiveness of the Prospective Target

The analysis typically begins at a relatively superficial level by identifying obvious problems that would jeopardize the achievement of the acquirer’s goals. Such problems might include imminent bankruptcy, significant off-balance-sheet liabilities, material legal problems, employee retention issues, regulatory troubles, etc. If no deal-breaking problems surface, it is time to begin a more intensive review. If problems do arise, however, the target can be eliminated from consideration before the process becomes costly.

The due diligence process commonly consists of the following four steps:

Step 1. Setting initial due diligence parameters. Management will need to make a preliminary evaluation of the areas of key importance to the success of the acquisition. For instance, human resources and employee retention will be critical issues in the acquisition of many types of service firms (accounting firms, medical practices, etc.). The issue may (or may not) be less critical when the strategic objective is to acquire the product and technologi¬cal assets of a manufacturing company.

Step 2. Selecting the due diligence team. Just as the process of buying real estate requires the combined efforts of a building inspector, surveyor and title agent, the process of acquiring a com-pany also entails some degree of team effort. The team will be selected based on the parameters set forth in Step 1, and will typically involve members such as:

• Management and employees of the acquirer,
• Legal counsel,
• Valuation advisor,
• CPA, and
• Technical consultant.

Many of the tasks will involve a coordination of efforts among members of the team. For example, an examination of any patents involved in the acquisition might require the attention of (1) legal counsel, who will evaluate the strength of the patents and their level of transferability to management’s intended purposes; (2) a valuation advisor, who will analyze the patents’ ability to
enhance the company’s future ROI; and (3) management, who will determine whether the underlying products or processes fit the acquirer’s strategic plan.

Step 3. Preparing and executing the preliminary investigation. Management will work with the team members to identify issues that require prompt attention. These will typically be the issues that will affect management’s decision to proceed with the acquisition, and at what price. The plan should be broad and relatively shallow, with enough coverage of the company’s operating, legal and financial characteristics to enable the team members to identify areas that require more detailed procedures. The goal of this preliminary investigation is to identify deal-breaking issues before money and other resources (i.e., management’s time and attention) are committed to a detailed due diligence study. Examples of problems that may be serious enough for the acquirer to consider abandoning the acquisition include:

• Dishonesty or concealing of facts by the seller and/or target management,
• Poor internal controls (accounting or otherwise),
• Material misstatements in the financial statements,
• Serious questions regarding management succession or employee retention issues,
• Significant contingent liabilities (legal, environmental, etc.),
• Uncertainty about customer retention, and
• An apparent inability of the target to fulfill the strategic objectives sought by the acquirer.

Step 4. Preparing and executing the detailed due diligence plan. After completing Step 3, management should reconvene with the other team members and solicit recommendations regarding detailed due diligence procedures. At this point, there should be a reasonable level of comfort that the acquisition is feasible and has a reasonable chance of achieving corporate goals. After reflecting on and discussing these recommendations, management should work with the team members to create a detailed plan of action.

The plan should be designed to ensure that, by the time the investigation is completed, everyone thoroughly understands the important issues and unnecessary or duplicated effort is kept to a minimum. It should be written in outline form so each task is distinct, clearly identifiable and assignable to one team member. This allows for personal accountability and ensures that nothing goes undone.

It is also a good idea to clearly identify the questions that will be answered upon completion of each task. The answer to each question should affect:

1. Whether to make the acquisition,
2. How much to pay for the company,
3. How to structure the acquisition, or
4. How to deal with any post-acquisition opera¬tional, accounting or legal issues.

If the answer to a question does not address one or more of these issues, then perhaps the underlying task is unnecessary or needs to be modified.

Management is charged with the responsibility of coordinating the efforts of the due diligence process and will require ongoing communication with each team member to ensure smooth and timely progress. Also, while the team members should be encouraged to make recommendations based on information discovered through the process, it is ultimately management’s responsibility to make key decisions based on such information.

The Detailed Due Diligence Investigation

An abbreviated checklist of issues which will likely need to be addressed during the detailed investigation (Step 4) includes:

Corporate Background

• Articles of incorporation,
• States in which company is licensed to do business
• Changes in corporate name or purpose,
• Classes of stock or other securities,
• Concentration of ownership, and
• Issues discussed in corporate directors’ meetings.

Financial Data

• Source and authenticity of financial data,
• Analysis of assets and liabilities,
• Accounting methods and practices,
• Related-party transactions,
• Contingent liabilities,
• Historical profits and losses,
• Profitability (gross profit, operating profit, pretax profit, net profit),
• Nonrecurring revenues and expenses,
• Sales volume by product,
• Order backlog,
• Internal controls,
• Revenue and expense trends,
• Fixed and variable costs, and
• Financial budgets and forecasts.

Products

• Major classifications and relative importance,
• Descriptions of all products,
• Analysis of seasonality/cyclicality,
• Primary competitors,
• Market share,
• Registered trademarks or trade names,
• Historical marketing strategies and initiatives,
• Product safety,
• Quality standards,
• Supply relationships, and
• Regulatory issues.

Production Methods

• Fabrication and assembly methods,
• Compatibility with acquirer’s processes,
• Production controls,
• Salvage management,
• Storage and distribution,
• Safety, productivity and efficiency, and
• Waste treatment/disposal.

Personnel

• Organization chart,
• Duties and qualifications of key management personnel,
• Employment and noncompete contracts,
• Employee morale,
• Management succession,
• Post-acquisition employee and management retention,
• Wages and benefits,
• Union considerations, and
• Corporate personnel policies and procedures.

Facilities

• Owned land and buildings,
• Leased land and buildings,
• Suitability of facilities for other purposes,
• Market-level lease rates for leased properties,
• Equipment records (accounting and maintenance),
• Operating vs. capital equipment leases,
• Utilities, and
• Spare capacity.

Research and Development (R&D)

• Existing patent portfolio,
• Patents pending,
• Research in progress,
• Commercial viability of R&D efforts, and
• Documentation policies and practices.

Legal

• States of incorporation,
• Rights of shareholders,
• “Blue Sky” laws,
• Corporate charters and bylaws,
• Executory contracts,
• Title to owned assets,
• Lease rights and obligations of leased assets,
• Strength of patent protection,
• Contingent liabilities, and
• Antitrust issues.

Not all of the above issues will be pertinent in every circumstance and many issues not listed above may deserve consideration as well. Each due diligence plan must be tailored to the specific circumstances of the subject company. If a one-size-fits-all approach is employed, the acquirer runs a significant risk of doing too little (and exposing itself to otherwise avoidable problems) or doing too much (and incurring more expense than necessary). In fact, it is quite possible to do both.

Responding to Issues Raised in the Due Diligence Process

The conclusion of the due diligence process is not the time for “buyer’s remorse,” where unwarranted attention is paid to the insignificant weaknesses that invariably exist in any business. Rather, it is the time to constructively deal with issues that can realistically be overcome. Depending on the nature of these issues, the acquirer can often take steps to minimize future exposure to problems and their consequences. Such steps may include:

• Structuring contingent payments into purchase terms,
• Requiring escrow accounts funded by the seller to immunize a contingent liability,
• Developing contingency plans, and
• Abandoning the transaction (obviously, the last resort).

Due Diligence is an Essential Stage

It is critical to understand that due diligence is an essential part of any well-executed acquisition process. Due diligence is a structured, systematic research effort used to accumulate the facts necessary to make an informed decision regarding an acquisition candidate, thereby increasing the chances of the acquisition’s success (both during and after the transaction). The process is not mysterious or unfathomable, although it may at first seem confusing. Due diligence should not (and, indeed, cannot) simply be delegated to outside professionals, although these professionals will certainly contribute to management’s ability to carry it out. By working together, management and its advisors can timely and efficiently identify and execute those due diligence procedures that will most improve the likelihood that the acquisition will achieve the goals desired by the acquirer.