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The Role of Due Diligence in Business Mergers & Acquisitions

Oct 28th, 2016 • Gary Brownlee

“Marry in haste, repent in leisure”

Overeager acquirers of businesses, large and small, are all too familiar with the above aphorism. How many prospective buyers get caught up in the thrill of the chase or let ego drive the process instead of a sober analysis of both external and internal factors essential to a successful transaction? A lot, if history is a guide.

Business acquisitions can go south from a dizzying array of possibilities, some controllable, some less so. A roundup of the usual culprits includes: 1) Overpayment, 2) Poor cultural fit, 3) Botched infrastructure integration, e.g., operations or systems, 4) Customer exodus, and 5) Unexpected changes in environmental conditions like macroeconomic or interest rate changes.

This post will focus on the role that a sound due diligence process around financial management activities can play in minimizing the risk of a deal gone bad. While a prospective buyer cannot control broader economic trends he or she can take steps to verify that what is being bought is what is advertised for sale. The following FAQs can help guide the small business owner through the “tire-kicking” aspect of a merger or acquisition:

  • Who should request that a due diligence process be performed for a prospective merger or purchase?

Everyone. You wouldn’t buy a house sight unseen, so why would you attempt to buy a business that way? If a potential seller balks at an examination of his or her books just walk away. A lack of transparency is at best an indication of disarray of pertinent financial or customer information-making an informed estimate of value impossible-and, at worst, an act of bad faith. Be wary of assertions by a potential seller that there is a time urgency about completing a deal. That can be a smokescreen to preclude or limit a thorough examination of the quality of a balance sheet, income statement or customer list.

  • But the prospective seller likes to play it close to the vest and balks at opening the books to an inspection. What can a potential buyer do?

Offer to provide a non-disclosure agreement. The prospective buyer should also act in good faith by not divulging customer lists, trade secrets, employee compensation or other confidential information or material of the target. Non-disclosure agreements are a common business practice in acquisition situations and provide the prospective seller with legal protection against unauthorized use or disclosure of confidential material. Most accountants, attorneys who are active in commercial law, or business valuation professionals will be able to provide this type of agreement.

  • Who is best able to conduct an examination of the books and operations of a target firm?

Like a lot of things in life—it depends. Prospective acquirers that employ their own accounting and finance professionals may be able to conduct an effective due diligence process without outside assistance. Business owners not having the luxury of having such expertise on their staffs typically will turn to their outside accountants or to credentialed business valuation professionals. Be aware that outside parties will perform work on a fee basis so be sure to gain clarity up front about the scope of work to be performed and the basis for fees to be assessed.

  • What does the due diligence process typically encompass?

At minimum the due diligence process should verify the existence and accuracy of assets, liabilities, revenues and expenses. It should also attempt to identify contingent transactions or events that will have an impact on cash flows or net worth like impending asset write-downs, legal claims against the firm, lease expirations or other future contractual obligations, to name a few.

The due diligence process should also identify intangible, non-earning assets carried on the firm’s books like goodwill and attempt to estimate the true value of trademarks patents and other intellectual property that might be carried on the balance sheet.

Another area deserving a high degree of scrutiny relates to transactions between the owner(s) and the firm, including loans to or from each other or affiliated businesses and the terms of such transactions. Also, the due diligence process should ascertain those expenses that an owner may run through the business that are of a personal nature in order to accurately assess the true cash generation history of the business.

An experienced due diligence practitioner should apply a structured template to ensure that any review of the target’s books and operations is comprehensive and credible.

  • What do I do with the results of the due diligence process?

In short, decide if the deal is worth doing at all or if a “haircut” needs to be made to the asking price of the prospective seller. Disciplined buyers are unafraid to walk away from a deal if material discrepancies are found in representations of sellers. Otherwise, the discovery and validation process can serve as the basis for negotiation of a final price.

  • Does the due diligence process solely benefit prospective buyers?

Business owners interested in eventually selling their firms can also benefit from an independent assessment of the quality of their books by a valuation professional. Such a pre-emptive review can identify conditions and issues that would be likely to be unearthed by a buyer and can minimize the adverse impact of valuation adjustments at the negotiation table.

This blog provided for informational purposes only and should not be considered legal advice.