12 May Due Diligence: Penny Wise, Pound Foolish?
You decided two years ago you wanted to acquire a competitor. You’ve spent months talking to a host of different companies and have finally found the perfect acquisition. You know it makes sense, you’ll be able to expand geographically and you’ll be able to add a couple of great products to your existing product line. You’ve heard people talk about due diligence before, but you’ve been in this industry long enough to “know” this is the right company for you.
In addition, due diligence costs time and money and you’ve spent enough time and money on this project already. You’ve negotiated a great price, so let’s just get the deal done and get going.
So, what’s the problem?
Typically due diligence is left to the very end of the process, by which time the momentum of the deal and willingness of parties to complete the deal results in blind faith that it will be a successful acquisition. It is easy to ignore problems and is impossible to be impartial if you want the deal to go ahead. Due diligence needs to be taken seriously and conducted without bias.
Why is it so important?
In short, many acquisitions and mergers go sour even in the very best of circumstances. Significant attention and research needs to be done to predict, expose and prevent problems before they occur, and in many cases to walk away from a deal if it doesn’t make sense. Losing thousands now is better than losing millions later.
The financial viability of the acquisition needs to include a bottom-up analysis of all the potential costs of the acquisition and integration of the target company. These “unexpected” costs can often be predicted in advance if you take the time to thoroughly investigate the target company. So the next thing to do after deciding to acquire this company is to look for every reason not to go ahead. Below, we list some of the important business issues to examine.
Essential Elements of Due Diligence
management accounts, capital expenditures, ratios, debt capacity, verification of reported financials, inventory value, accounts receivable risk, identification of adverse trends.
growth rate, growth patterns, micro and macroeconomic trends and cyclicality, risk of product obsolescence, market share, performance of business relative to competition.
customer base, customer satisfaction, customer retention and loyalty, risk of customer loss after acquisition, order volume changes, new demands on quality or product design.
strengths and weaknesses of key competitors, changes in competitive strategy, barriers to entry, proprietary capabilities, potential or emerging competitors, supplier base, market share, pricing strategies, product and service development.
continuing availability of materials, trends in supplier base, changes in supplier leverage, changes in material cost.
employee tenure and turnover, compensation and demographics, employment contracts, remuneration and benefits, training and skills gaps, retention and reliance on key employees, availability of capable management, unionization, management structure, management philosophy and style, formal and informal employee networks.
taxes, pending litigation, environmental factors, employees, violations, liens.
customer satisfaction and service history, history of regulatory violations, Better Business Bureau records, late shipment and poor quality history, customer attitudes, credit history: with banks and suppliers, media exposure.
loss of proprietary capabilities, patent expiration, required capital expenditures, insurance cost changes, purchasing procedures, inventory management, production technology, resource requirements, IT systems and expenditure.
statutory records, tax filings, property titles, contracts, corporate registers, good standing in desired operating regions.
Property, Plant & Equipment (PP&E):
condition of property, availability of equipment and facilities post-acquisition, lease expiration, lease terms, zoning, room for expansion.
integration risks of merging multiple businesses, environmental issues, health and safety issues, insurance policies, internal controls.
Opportunities to Investigate in Due Diligence
customer base expansion, increase volume to existing customers, new product extensions, marketing efforts, inside and outside sales efforts, sales strategy.
Price per unit growth:
product improvements and services that add value, customer segmentation and targeted pricing.
cash flow and debt service modeling with various scenarios.
productivity enhancement, implementation of IT systems, plant layout and workflow redesign, supplier cost reduction, asset utilization improvements.
potential scale efficiencies, availability of add-on acquisitions, vertical integration opportunities.
exit strategy should be developed and written with options based upon events, appeal to strategic or financial buyers, potential for IPO or private resale, timeline and transition plan.
Create a report of the risks and rewards with their value weighted by probability. Added value is to identify the areas to address in a written integration plan and forecast the cost of integration and/or additional post closing investment needed.
Data needs to be obtained through various sources including plant and equipment inspections, financial statement reviews, government records, industry research, interviews with customers, suppliers, employees and management, consultations with outside experts and other sources.
Don’t make the mistake that so many smart business owners have made before you. If everything goes well, you’ll get through this with information that supports and justifies your desire to go ahead in the first place.