DUE DILIGENCE
We initially encountered the term "due diligence" during the 1960s, when Wall Street was engaged in one of its periodic frenzied attempts to sell anything and everything into public markets crying for new issues. Due diligence at that time was normally performed by an underwriting group and generally consisted of one or more lengthy meetings during which a great many questions were asked by representatives of the underwriting group, and answered by key members of the management team of the company seeking the IPO.
Although we were involved with the M&A process at that time, we do not recall hearing the term used in this context until many years later. We were surprised when two representatives of a particularly high flying public corporation invited us to perform due diligence on a group of their subsidiary organizations in which we were interested as potential targets. We can recall wondering how much in the way of review could be accomplished by sitting around a conference table and asking even the most brilliant and piercing questions.
Several years ago, while working on behalf of a client, following a lengthy process of detailed offers, counter offers, and finally acceptance, we were asked to quantify the probability of the deal falling out of bed after that point. Being naturally conservative, we nevertheless gave the transaction a better than 50/50 chance of success, and opined that it was reasonably unlikely to fail, assuming that we truly had a willing buyer and seller. We were well acquainted with the buyer's law firm, and knew them to be deal makers, and not deal breakers. We also knew that buyer's management were reasonable individuals, interested in completing the transaction and willing to address any sensible compromise.
Our buyer client was relatively new to us, as well as to the process of acquisition. We had not yet been involved with their due diligence procedures, nor had we been asked to assist or make recommendations about their due diligence process. One of our key client contacts sent us a copy of the due diligence memo and audit program, which had been delivered to buyer's management and members of their newly formed due diligence team. Even though we were not directly involved, the individual knew that we were on a monthly retainer and believed that he should benefit from any possible expertise available to him.
The due diligence program delivered to us looked like a deal maker's worst nightmare! Somebody was apparently determined to use the review process as a means to inform every second tier manager about details of the upcoming transaction, and solicit their input to make it a "better" deal for all concerned.
Unfortunately, as deals commonly work, it is not unusual for only a few individuals to have a complete understanding of the operations of a candidate when an offer is made and accepted. In many cases, this small cadre represents the only people who are even aware of the existence of an impending acquisition. In too many instances, the transaction is then negotiated and closed, after which it is dumped into the laps of accounting, human resources, and the whole spectrum of support personnel. These people are then faced with the huge and often very costly problem of coming up to speed, while corporate development people move on to the next target and "operational" people begin their part of the integration process.
Something of this nature had apparently occurred with our client during an earlier transaction, and someone was attempting to ensure that it never happened again. There was no doubt in our mind that, had such a program been forced on the seller, it would have resulted in nothing less than discontinuance of negotiations and the end of the deal.
The problems commenced with our client assigning more people to the due diligence effort than the total number represented on the seller's combined accounting and administrative staffs. They were all scheduled to arrive at seller's location simultaneously. Things only got worse as we reviewed the planned scope of the review and its infinite level of detail. For openers, the list of documents requested included each and every contract for services being performed by seller (a relatively small computer consulting firm); every contract for leased equipment of any value; details on every purchase commitment in excess of $25; all personnel files; and complete, detailed fixed asset listings, even though their carrying value represented less than two percent of seller's rather small net worth. We were eventually able to convince our client to modify the program to some degree but still chuckle with seller, now fortunately a valued member of buyer's management, about "the due diligence effort from hell."
Although appropriate standards for due diligence must be developed and applied, there should be no such thing as a completely standard due diligence program! Just as each and every transaction is unique in some manner, so must due diligence be modified to fit individual situations.
Many buyers view the due diligence process as something that involves only reviews of financial and specific operational matters, such as inventory control, or manufacturing processes. Such should not be the case. Due diligence should properly be a comprehensive review of every aspect of the seller's company. The thing to bear in mind when designing this review is that it should, at most, equate to an annual audit in scope and breadth. Maintaining this metaphor, a due diligence review should be designed to test significant and material aspects of the business, while disturbing seller's everyday operations as little as possible.
One of the most irritating things to a newly acquired management team is heavy handed interference from an unfamiliar parent, coming close on the heels of many assurances of virtually unlimited autonomy. Excessive levels of due diligence can be a dead giveaway that all things in the future will not be as comfortable as they were portrayed during negotiations. We do not advocate laxness in the due diligence process but only the careful attention of senior management to ensure that the review is restricted to important and material features of the seller's company. When buying a company that sells a very mature product line, for instance, we do not feel it appropriate to spend any meaningful time in determinations as to the products' efficiency and workability. If buyer's eventual intent is to modify this product line, this should certainly be included in talks with seller and plans for future operations but it should not be considered as part of a due diligence review.
It is particularly important to consider where the due diligence review fits on the overall time line of most transactions. Buyer has normally been involved with the acquisition process for some period of time. Seller may have only recently made the decision to sell, difficult under any circumstances. If there are several people who own minority interests in the seller company, and who are also key to seller's operation, they may not yet have been informed of the transaction. In all likelihood, such individuals have been privy to rumors, and they could be pleased with future prospects, or they could be getting their resumes in order. For these and many other good and proper reasons, there is uncertainty on the part of both buyer and seller.
Under usual circumstances, buyer and seller have only recently transitioned from that mode in which they were attempting to check out cultural similarities and determine whether or not they want to be involved together at all. They have also had to address the many problems involved with negotiating and executing a mutually acceptable offer. While many offers represent the soul of simplicity, others may be complex enough to represent the essence of a purchase agreement. In either circumstance, the early courtship phase has ended and both parties are beginning to take the other's measure for the future. Most important, seller may have begun to wonder if the whole process is worth it, and buyer should be attempting not to exacerbate this feeling.
We have seen clients in varying service industries who have spent immoderate amounts of time and energy reviewing accounts receivable, billed and unbilled. It is certainly appropriate to study accounts receivable agings, collections, and existing provisions for doubtful accounts. There are even circumstances which could justify some written or other types of positive confirmations of accounts receivables and work in progress on a test basis. We believe, however, that alternative methods can be used to replace the potentially damaging effects of too much review at early stages of a negotiation.
Excessive efforts to review accounts receivable, as well as most other financial aspects of the review can be eliminated by at least two other techniques: seller representations and warranties, escrow accounts, or a combination of the two. The first method is generally wholly applicable if a purchase is being made from a large, financially sound corporate seller or an extremely wealthy group of individual shareholders. The second can be brought into play when dealing with individuals or other sellers who might reasonably be expected to disperse their purchase proceeds rapidly following the close of the transaction.
In setting the stage for a due diligence review it is perfectly appropriate and even very desirable for one or more individuals who have been involved with negotiations to talk with selling management about potentially unpleasant future items such as seller's representations and warranties. This can not only pave the way for a smoother negotiation process but can also introduce the concept of purchase price hold backs to support or soften the impact of warranties. We have often encountered shareholder groups with widely diverse interests who begin by stating that they would make absolutely no representations or warranties. This attitude can usually be tempered quickly by pointing out the common representation which states that seller corporation is properly registered and entitled to do business in states where it has operated for many years. We have rarely met a seller who would not agree to that one, and this leads on to some of the more difficult representations and warranties which can usually be negotiated in some mutually agreed upon and reasonable format.
With an adequate set of seller representations and warranties and sufficient amounts in a retained escrow account we believe that only minimal due diligence work would be required on balance sheet accounts. Such work, for instance, would assist in determining how much to withhold and for what length of time. (In working with seller hold back accounts we have always recommended that clients request that funds be held in the trust account of one of the law firms involved with the transaction. We also suggest that interest, if any, be held for the benefit of seller.) (To be continued.)
We tried to make several key points in our first article on due diligence. These included our belief that improperly planned, excessive, or oppressive due diligence can kill a golden goose before the first egg has been laid. During the past year we heard of a situation that may well illustrate this point in a classic manner.
The buyer company in question has revenue slightly in excess of $1 billion. It is organized in an uncomplicated manner, with a small group of divisional vice presidents, reporting through three group vice presidents to the CEO. The division managers and those who report to them have traditionally been permitted to exercise a reasonably high degree of autonomy in their day-to-day operations. Not unexpectedly, as the organization grew, this operational freedom produced some amount of intra-company competition for business that might be perceived as crossing divisional borders. This generally healthy competitive spirit has extended naturally beyond revenue accretion, and presently includes competition for other things, such as capital expenditures, including acquisition funding.Acquisitions are sought out and generally negotiated to the point of board approval by operating division management. Division personnel are also used to perform due diligence. During the past year the CEO has decreed that due diligence teams must be drawn exclusively from divisions other than the one responsible for a potential acquisition. In our opinion this may well be a formula for inevitable disaster.
The company has made a series of small acquisitions over the years, many of which were simply takeovers of distressed organizations in their existing business segments. Not unexpectedly, some of these transactions have resulted in excellent additions to the company's business, while others have experienced varying but lesser degrees of success. During the preceding five years, however, the company has begun an increasingly well defined acquisition program to enhance strategic growth.
As part of this process, management has trained a number of key administrative people in every division to be involved with due diligence. These people, experienced in finance, contract administration, law, human resources, and similar disciplines, have generally ramped up rapidly on the learning curve. With each due diligence review they have become more familiar with the process. They have also become more professional in their performance, and in their reactions to those problems normally encountered in any due diligence review. Equally important in any organization offering a high degree of autonomy, these individuals, representing their particular operating divisions, have been able to impart their feelings concerning cultural similarities and differences between themselves and those employees of the candidate company with whom they are in contact.
We generally favor the use of a corporate group to maintain oversight on the acquisition function. We have also worked in situations where all or a major part of the process has been a successful divisional responsibility. This article is not intended to cover the debate over whether acquisitions should originate from operating organizations or a central corporate M&A group.
Whichever approach may be chosen by a company, we do not believe that due diligence should ever offer a potential for the exercise of intra-company rivalry. The due diligence function should be designed to provide information within the confines of the overall acquisition process, and should be viewed as and where it fits within that process. It should be conducted in an objective, professional manner, designed to produce accurate and unbiased information, based on which senior management can make valid future judgments concerning their actions in a transaction. Clearly, management should take every step to ensure that information is gathered and reported without bias in either direction.
When we assist clients with due diligence, we like to make certain that more than one representative of higher level management is made part of the team. These individuals should be responsible for obtaining an overview of the candidate's business. In a due diligence audit program, this process is simply referred to as reviewing the income stream.
This aspect of due diligence is deliberately vague as to specific instructions, but could be summed up by a single sentence: Through discussions with senior management and higher level operational people, discover exactly how the candidate company derives its income, and where it spends its money.
This is a calculatedly broad charter in what should typically be a very specific review program but it usually accomplishes what it is meant to do. We try to impress clients with the fact that use of high level management people for this aspect of due diligence is essential, and does not necessarily require their involvement for the full time of the review. Effective results will be achieved if management representatives come away with the understanding originally sought. In accomplishing this task, the average upper level management individual will usually leave a long list of specific questions with the due diligence team leader. This serves to accomplish two goals simultaneously: a fuller understanding of the candidate's operations and the addition of a new and different dimension for the detail team.
While one portion of the due diligence team is concerned with operational details, another group might normally be involved with other aspects of the candidate company's capabilities. Having asked about the income stream, it is also the responsibility of a good due diligence effort to learn more of the details behind the services or products that support the revenue stream. The extent of the review and the depth to which it is taken will generally depend on the nature of the products or services under consideration.
When dealing with the acquisition of an entity that is purely involved with personal services, such as a consulting organization, a review of the revenue stream will necessarily be conducted in somewhat of a subjective manner. Much of the historic success of these organizations will have depended on personal performance, and the sales and project management capabilities of key people. For this reason, future growth and profitability will also necessarily be based on such key people and therefore closely tied to those incentives which will make them continue to perform successfully in the new organization.
Accordingly, those members of the team responsible for evaluating the performance of such people should be individuals with different skills than those normally used in such reviews. In our opinion, they should be senior managers, with the experience and intuitive skills normally used to make a final decision to hire the kind of people they are reviewing. This should include the same prudent steps used in a hiring situation, including but not limited to discreet reference checks and gathering of substantive data relating to market perception of those individuals who represent the key management of the candidate company.
The other extreme of due diligence, as it relates to the income producing process, would involve a target organization that is involved with the production of some tangible product. For this discussion, we would make this is a broad category, involving products ranging all the way from consumer electronics, to manufactured children's toys, to petrochemicals.
The preceding examples have deliberately been chosen for their obvious and extreme differences. In our opinion, however, there are also two clear, essential similarities which would allow for comparable due diligence techniques in either instance: (i) whatever the end product in a manufacturing or process situation, buyers must ensure that raw materials coming in at one end of the line make it to the other end of the line in a profitable and efficient manner, and (ii) that the seller is not holding uneconomical or unsaleable quantities of raw materials, work in process, or finished goods.
The preceding statements are deliberately simplistic in nature. They are intended to illustrate once again that due diligence is generally not intended to disclose essential problems which should have become apparent at some earlier phase of the acquisition process or which will be covered by seller's representations and warranties.
There are circumstances in which due diligence can be considered a review to validate information previously obtained. In most instances, the financial and administrative portions of the process will be designed as an "audit" of financial statements, a review of tax returns and practices, and an examination of ongoing accounting and administrative practices. This review would also assist in determining whether the candidate's systems will integrate with those of the buyer and if so, at what speed this should be accomplished.
Occasionally, there are particular components of a transaction that must be reevaluated in greater depth as part of due diligence. Such things might have arisen out of the due diligence review itself, might have been known when the review began, or might come up at its conclusion.
There are many transactions where a key ingredient of the seller's value resides in their customer/client relationships and/or the potential for future growth of their marketplace. Traditional market research techniques will often provide information concerning the future of an entire market segment. Such research can be done by buyer's personnel or it can be obtained by using one or more outside consultants.
In almost every case, however, one invaluable source of information concerning future growth would be direct contact with seller's customers/clients, or competitors. We will assume that the due diligence review is being conducted in normal time sequence, having been preceded by preliminary meetings, execution of a non-disclosure agreement, price negotiation, offer, and acceptance.
In our experience, sellers will rarely permit buyer personnel or any other outsider to contact people on their customer list at any point earlier than the due diligence phase. Assuming that the person who will speak with customers on buyer's behalf is not someone with whom they are familiar, it is essential that buyer and seller agree on a valid reason for the contact. Since most parties will concur that full disclosure to customers is inappropriate at this stage, a small amount of innocent subterfuge would not be out of order.
Most customers, for instance, would not hesitate to respond to a telephone solicitation from a "prospective customer" seeking a reference. In some industry segments buyer's name could be openly stated, with the excuse being that they are considering some type of teaming arrangement with seller. Whatever approach is decided upon, the parties must remember to share the impending customer contact with those who normally function in this capacity. This will compound the original subterfuge slightly but it will ensure that things continue to move smoothly and without an inadvertent and premature announcement. (To be continued)