Both parties have signed the Letter of Intent in which the ground rules for conducting the due diligence have been outlined. As the buyer, you will need to put together a team of due diligence experts; e.g., appraisers, accountants, lawyers, environmentalists, to verify and challenge all the representations. Notwithstanding the expert’s views, herewith a brief check list for the buyer to confront the seller.
Operations
Review the current year’s financial statements; e.g., interim, monthly, quarterly, compared to the budget. Focus on the incoming orders and analyze the backlog.
Industry structure
Compared to the industry, analyze the company’s products and distribution channels. Figure the percentage of sales by product line, review the pricing policies such as discount structure and discuss the product warranties.
Marketing
Ask for a list of the top 50 customers and sales breakdown by country (if export), and the company’s market share compared to competitors. Discuss the potential of gain or loss of market share and the extent a barrier exists to entry for new competition.
Manufacturing
Tour the production facility to evaluate the condition, utilization and capacity. Find out the age of the facility, the square footage, the cost and current value, and whether it is owned or leased. Review the manufacturing process: master schedule, flow chart, shifts, employees, lead time by product, manufacturing time by product, amount of outsourcing, key suppliers, etc.
Human resources
Discuss the names, positions and responsibilities of the key management people. Understand the relationship with labor, the employee turnover and the incentive bonus plan.
Balance sheet
Concentrate on three items for due diligence purposes. The accounts receivable balance and aging should be scrutinized in relation to the bad debt analysis and reserves. A list of the top twenty-five accounts receivable is helpful. The inventory analysis should be sub-totaled to include raw, work-in-process, and finished goods, and should include turnover rate, order completion rate, aging, reserve amount and policy for write-offs. The accounts payable aging, payment policy, and various credit terms are important to analyze.
Environmental problems
Ten or twenty years ago there was little or no concern for ground contamination, water pollution or asbestos problems. Nowadays, these can be a major reason transactions are aborted.
Patents, trademarks and copyrights
Are these intangibles transferable? In one case, a machine tool manufacturer had licensed the well known brand name to an Asian company, thus diluting the value of the goodwill for the potential buyer. Do not assume anything in regards to these items as valuable patents to the business may be in the name of the individual, not the company.
If the selling company is a divestment from its parent, one has to be concerned to what extent the financials are consolidated or separated. For example, what assets and liabilities are carried on the parent books, e.g., real estate and bank debt? What expenses are carried on the parent books such as product liability insurance? If so, what is the history of claims, settlements and insurance costs? As a subsidiary, what is the status of the pension plan obligations, i.e., overfunded or underfunded? And what is the status of the retirement health benefits, i.e., obligations and costs? Such a divestment can be more complicated for those conducting the due diligence. Four areas of particular concern are as follows:
- That all costs are properly reflected whether it is products or services being bought or sold between the two entities.
- Business between the two entities is at an arm’s length basis and items are not bought and sold because of the inter-company relationship.
- The division or subsidiary has the quality and depth of management to successfully operate independent of the parent company.
- To what extent the parent company has access to services at favorable rates substantially reduces the cost to the division or subsidiary, e.g., accounting, tax, legal, insurance, benefits, information services.
The purpose of the due diligence will help you determine whether you want to go forward with the transaction or whether you want to re-negotiate the price and terms of the deal based on your findings. If you are going forward with the deal, you want to be sure you will be receiving the assets you expect, that there will not be any unexpected liabilities or unexpected expenses post acquisition.
In reviewing the highlights of due diligence, it is important to keep three points in mind.
- Verify the critical elements of the acquisition. Concentrate on the key issues of the target company and its industry. If you are buying a high-tech company, concentrate on transferring intellectual property without encumbrances. If you are buying a consumer product company, concentrate on possible product returns or recalls. And if you are buying a heavy manufacturer, concentrate on environmental issues.
- Weigh the risk/reward factors of doing the deal. Small repercussions may be acceptable, but disasters must be avoided.
- The net result of due diligence is not necessarily a “go or no-go” with the acquisition. You may still want to buy the company, but due to certain circumstances you may deem it necessary to re-negotiate the deal by changing the price or structure.
In conclusion, when a buyer and seller sign the Letter of Intent, they certainly have reached a milestone. Unfortunately, “The Deal Is Not Almost Done” as the title of this article suggests. To paraphrase Winston Churchill, “It is not the beginning of the end, but the end of the beginning.”
