EXIT STRATEGIES: Due diligence

Once the parties have agreed the business terms of the acquisition, the potential acquirer will proceed to a full analysis of the investment opportunity.

At this point, analysts, lawyers and accountants acting on behalf of the acquirer will undertake a due diligence investigation.

The buyer will incur considerable costs in this investigation and will want to ensure the selling firm is acting in good faith during this period. To protect themselves, the buyer may request the seller execute an exclusivity agreement where the seller agrees not to proceed with acquisition discussions with any other party during the due diligence period. A penalty may be agreed for a breach of this condition.

Alternatively, in a competitive bidding process, there may be a shortlist of parties which undertake the due diligence assessment concurrently.

One objective of the due diligence process is to investigate the firm to see if the business itself has any major problems which have not been identified in the information already provided to the acquirer. The due diligence process will undertake a validation of all aspects of the existing business as presented in the documents supplied (information memorandum, business plan, prior financial reports and so on). This investigation would include most of the following (dependent on a share or asset sale):

• Background checks on the key executives and key employees (subject to privacy laws);
• Review of all corporate documents including Board minutes;
• An examination of all shareholder information including share classes, rights, obligations, options, warrants, covenants and minority interests;
• All material agreements with external parties, especially those that impact revenue or expenses or that involve guarantees or restrictions on trade;
• Any employee agreements including management contracts, option schemes, remuneration arrangements, pension arrangements, commission and bonus payments;
• Review of all financial information and additional investigations where necessary to validate key numbers in financial reports and budgets;
• Inspection of all key contracts including leases, mortgages and debentures;
• Review of all compliance requirements;
• Review of all taxation filings and liabilities;
• Review of any current and potential litigation;
• Review of all insurance and any outstanding claims;
• Validation of all intellectual property ownership;
• Examination and verification of all real property ownership;
• Interviews with major customers, suppliers and distributors;
• Verification of costs, expense levels and purchase commitments;
• Assessment of plant and equipment and capital expenditure requirements;
• Review of intellectual property rights, including patents;
• Assessment of key employees;
• Review of inventory holdings including ageing.

This process will check the integrity and honesty of the firm as well as provide a view on how well the business is managed and on the adequacy and accuracy of the information which is being used in the business. It will also uncover how well the key executives understand their own business and the ease with which they are able to access and provide additional details necessary to the analysis.

A key part of the due diligence process is for the buyer to identify anything which would incur additional costs, create delays or expose the buyer to actual or potential liabilities which are not identified in the information provided to the buyer. This may lead to price adjustment or additional clauses in the sale document. Items which frequently create problems include:

• Non standard customer contracts;
• Non standard supplier agreements;
• Harsh lease conditions;
• Loose IP agreements;
• Overly generous reward and remuneration systems;
• Generous health or vacations benefits;
• Poor reporting systems;
• Out of date equipment or evidence of poor quality outputs;
• Use of company funds or resources for personal use;
• Pre-existing obligations, rights, commitments or restrictions;
• Unusual shareholders rights, legal structures, joint ventures, option schemes or anti-dilution arrangements.
• Punitive rights of existing debt holders;
• Excess inventory;
• Overvalued assets;
• Understated provisions.

A business which is effectively and efficiently run, has good customer, distributor and supplier relationships and has good internal reporting systems which monitor performance, ensure adherence to compliance regulations and protect the business from mistakes should have few problems in satisfying the buyer.

After the firm has satisfied the buyer with regard to its current operations, the buyer will turn their attention to an examination of those aspects of the future potential of the business which are critical to achieving the integration synergy and/or exploitation of opportunities presented by the acquisition.

For example, they may wish to validate the business projections and other planned targets and milestones which underpin the seller’s business plan. Or they may wish to validate the size and viability of the opportunity to generate new revenue based on the acquired assets and capabilities of the seller’s business. If achieving these targets is critical to meeting the ROI conditions of the investment, this is the area which exposes the buyer to the greatest risks.

This investigation will review the following:

• The identification of the prospective customer and the quality of the benefits the customer gains from the product or service;
• The size and growth rate of the prospective market;
• The size, strength and strategies of current and potential competitors;
• The quality of the intellectual property underpinning the projections;
• The quality of the sales, marketing and distribution strategies proposed;
• The likely ability of the management team to be able to execute the plan;
• Availability of executive and specialized staff needed to deliver on the plan;
• A detailed review of the likely cash flow over the expected investment period.

As the business gets older and more complex, the data needed to support a full due diligence becomes more extensive and probably harder to uncover. Few early stage businesses have the filing disciplines to keep adequate records or to file them in a manner which allows ready retrieval many years later. Smaller businesses may not take the trouble to document management or board decisions and then later find they cannot find the authorities which allowed them to make significant decisions which may have affected stakeholder rights.

This opens up the door for possible litigation from minority shareholders or other vested interests.

The best path for the potential seller is to undertake a vendor due diligence. This is a due diligence activity which is undertaken by professional advisors on behalf of the seller but from the viewpoint of a potential buyer. The outcome should be an action plan for the seller on what they need to do to bring their business up to date and in a position where they could meet the due diligence requirements of a potential acquirer. So rather than be surprised or penalized in the acquisition process, the seller who is prepared for due diligence has everything ready for the due diligence investigation.

It is unlikely any firm can submit to the due diligence inspection without there being some issues which need to be resolved. Firms which have not considered due diligence and have let compliance slide, are late with meeting new regulations or have inadequate internal information systems, may have a lot of work to do to bring themselves up to the mark. Thus it could easily take 18 months to two years just to put in all the performance and compliance monitoring systems to ensure these aspects of the business will be ready for a due diligence review. Since these systems should be there anyway, this is money well spent and should be done whether the business was being prepared for sale or not.

When you undertake a due diligence review of your business you will inevitably uncover numerous items which need attention. Some activities may simply bring files up to date and make information about company operations available in a more accessible and understandable format. Other items will require the implementation of new compliance reporting and monitoring systems, installation of new financial recording and analysis systems, restructuring of roles and responsibilities and so on.

These are aspects of your business which will have immediate payback in the current business but will also produce a more effective and efficient business for the new owner. The acquisition may be based on some level of integration of the seller’s business with the acquirer’s existing business. The buyer due diligence process will need to identify where integration needs to occur, the likely priority and timing of such an integration and the capability and willingness of the respective staff to make it happen. Included in that review will be issues such as:
• The need to open or close new offices, warehouses and manufacturing locations;
• The extent to which staff will be relocated, reassigned or have conditions of employment, remuneration, health benefits, entitlements, responsibilities or reporting lines changed;
• The extent to which information systems need to be integrated, merged or interfaced;
• The extent to which the cultures of those units which need to be integrated are alike;
• Whether suppliers, agents and distributors will continue and what costs and disruptions will occur if they are not.

Integration will take time, utilise senior executive time and require funding.
These costs and delays need to be factored into the investment evaluation.

To the extent that uncovered risks reduce the probability of achieving the desired outcome or delay the time to execute, the value of the potential investment declines. In some cases, the problems can be overcome by installing additional controls, renegotiating agreements and putting in place alternative strategies. However, these may result in additional costs or delays in executing the plan. To the extent problems cannot be easily resolved or structural changes are difficult to implement, the investment will incur greater risks. At some point the buyer will decide the risks are too great and will decide not to make the investment.

You need to see the integration process as a cost to the acquirer and, whatever the cost, it will be deducted from the potential gain from the acquisition. The more you can reduce the costs, time and stress of integration, the higher the potential value which can be assigned to your business.

Aspects of integration which you can influence in advance of a sale include:

• Moving customers and suppliers over to new relationships and systems, perhaps rewriting contracts, agreements and trading arrangements;
• Shifting business from some distributors and suppliers to those which have pre-existing arrangements with the acquirer;
• Closing down duplicate offices, warehouses and manufacturing facilities. This might include redundancies or relocating staff;
• Shifting financial reporting systems and transaction systems across to a common administrative system;
• Realigning remuneration, health, pension, vacation and other entitlements;
• Replacing staff who have left;
• Changing job descriptions, responsibilities and reporting lines;
• Re-branding products and services and re-designing sales collateral.

Ask yourself how you can help streamline any of these processes with your target acquirers. For example, do you have termination and/or change of ownership clauses in your contracts? Are you using industry standard terms of trade? Are your products based on common industry interface standards and use common industry components?

Take a good hard look at your business and ask yourself if everything you are doing makes sense and if it is contributing to adding value to a potential buyer.

It need not generate more revenue or even reduce costs for your business right now but consider the impact on the buyer. Whatever you can do to make the business easier to manage, increase the productivity or allow the buyer to focus on exploiting the potential can increase the value proposition.

Remember that your buyer may have other firms to look at. All other things being equal, the one which is the least effort to exploit is going to be the preferred deal.

If the investigation results in an agreement to proceed with the investment, the buyer will incur the costs of the due diligence plus the legal fees associated with the preparation or review of the investment agreement. These will be factored into the final price paid to the seller. Where more due diligence work needs to be undertaken, this will result in a lower final price to the seller.

The more prepared the seller is for due diligence, the lower the costs of the task, the shorter the time it will take and the more likely the buyer will be to go through with the deal. It is in the seller’s best interest to fully understand the due diligence process and undertake as much of the preparation work in advance as possible.

The advantage which accrues to the prepared firm is that this level of preparation indicates to the buyer that the seller understands how to manage its compliance and operating risks. Since these are often where the greatest risks for the buyer lie, this is good news to the buyer and should speed up the acquisition process. Where the buyer has a choice of acquisitions, the better managed one is more likely to also allow the buyer to more quickly execute on the opportunity. It becomes the preferred purchase.

The firm which is better prepared for a due diligence inspection also presents itself as being well managed. Firms which are seen to be efficient will find it easier to secure the support of champions in the purchaser’s organization and that will help get the deal done. Also never forget that the task of the seller is to collapse the time to get an agreement. Being efficient and well prepared creates the best chance of getting the deal done quickly and of preserving value for the seller’s shareholders.

Creating value is partly psychological. Buyers go into a deal anticipating problems and all their experience suggests they can expect them. They should be delighted when they find a business which operates efficiently and satisfies their due diligence investigation. Don’t forget that professional advisors who carry out due diligence projects have to justify their fees and are looking for ways to reduce the price paid by the buyer. If you can create a clean business, the buyer is likely to reduce the scope of the due diligence work. They won’t be willing to keep paying professional services fees if the service providers are not finding anything to justify further work.

Always keep in mind the golden rule of selling – the shorter the time it takes to get the due diligence complete, the higher the price you can expect and the more likely you will be to get the deal done.

Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the former Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia. A series of free eBooks for entrepreneurs and angel and VC investors can be found at his site here.