Due Diligence – Penny Wise, Pound Foolish?
You’ve spent months reviewing different companies and have finally found the perfect acquisition. You know it makes sense, you’ll be able to expand geographically and drive your company sales. You’ve negotiated a great price, so let’s just get the deal done and get going right! Well, not just yet. Due diligence is a critical step of the process, and primary way to verify what your buying is what your are buying!
Due diligence costs time and money and you’ve already spent considerable time and money on this project already.
So, what’s the problem? Frequently 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.
Key Points of Due Diligence:
Financials: management accounts, capital expenditures, ratios, debt capacity, verification of reported financials, inventory value, identification of adverse trends.
Industry: growth rate, growth patterns, micro and macroeconomic trends and cyclicality, market share, performance of business relative to competition.
Customers: customer base, customer satisfaction, customer retention and loyalty, risk of customer loss after acquisition
Competition: 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.
Suppliers: trends in supplier base, changes in supplier leverage, changes in material cost.
People: employee tenure and turnover, compensation rates, training and skills gaps, retention and reliance on key employees, availability of capable management, management philosophy and style.
Liabilities: taxes, employees, violations, liens.
Reputation: customer satisfaction and service history, Better Business Bureau records, poor quality history, customer attitudes.
Operations: loss of capabilities, required capital expenditures, purchasing procedures, inventory management.
Furniture, Fixtures & Equipment (FF&E): condition of property & equipment, lease expiration, lease terms, room for expansion.
Other Risks: integration risks of merging multiple businesses, environmental issues, health and safety issues, insurance policies, internal controls.
Opportunities to Investigate in Due Diligence
Sales: customer base expansion, increase volume to existing customers, new product and services, marketing efforts, inside and outside sales efforts, sales strategy.
Price per unit growth: product improvements and services that add value, customer segmentation.
Modeling: cash flow and debt service modeling with various scenarios.
Cost reduction: productivity enhancement, implementation of new POS systems, layout and workflow redesign, supplier cost reduction, asset utilization improvements.
Exit: It may seem early now, but an exit strategy should be developed and written to give context to the acquisition. Prepare a plan with options based upon events, appeal to strategic or financial buyers, timeline a transition plan. Don’t buy anything you can’t sell!
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 site and equipment review, 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.