White Paper: Starting Acquisition Due Diligence Off on the Right Foot
Good due diligence begins even before an acquisition prospect is identified. The buyer should determine beforehand which characteristics are desirable and which are undesirable. A modest amount of early planning can often streamline the search process by allowing management to expediently eliminate from consideration companies that will not further the goals of the acquirer.
The objective of due diligence is straightforward and simple. The acquirer is interested in minimizing its exposure to the many problems and pitfalls that can arise when making an acquisition. The due diligence process itself is decidedly less simple. The acquirer must begin with clear and explicit expectations of the benefits it hopes to gain by making the acquisition. Only by clearly understanding these expected benefits at the outset can the appropriate due diligence procedures be identified and efficiently carried out.
Goals of “increased sales” or “improved profitability” are only part of the picture. An acquisition itself will not improve profitability. Only the well-executed combining of complementary corporate resources (or dumb luck) will create value for the acquirer. The attractiveness of an acquisition should be measured by the expected return on the investment (ROI). If the expected ROI of the acquisition is (1) sufficiently high to justify the effort and (2) equal to or higher than the expected ROI associated with internal growth, the acquisition has the potential to be a good one.
Benefits typically sought by acquirers include one or all of the following:
Assessing the Attractiveness of the Prospective Target
The analysis typically begins at a relatively superficial level by identifying obvious problems that would jeopardize the achievement of the acquirer’s goals. Such problems might include imminent bankruptcy, significant off-balance-sheet liabilities, material legal problems, employee retention issues, regulatory troubles, etc. If no deal-breaking problems surface, it is time to begin a more intensive review. If problems do arise, however, the target can be eliminated from consideration before the process becomes costly.
The due diligence process commonly consists of the following four steps:
Step 1. Setting initial due diligence parameters. Management will need to make a preliminary evaluation of the areas of key importance to the success of the acquisition. For instance, human resources and employee retention will be critical issues in the acquisition of many types of service firms (accounting firms, medical practices, etc.). The issue may (or may not) be less critical when the strategic objective is to acquire the product and technologi¬cal assets of a manufacturing company.
Step 2. Selecting the due diligence team. Just as the process of buying real estate requires the combined efforts of a building inspector, surveyor and title agent, the process of acquiring a com-pany also entails some degree of team effort. The team will be selected based on the parameters set forth in Step 1, and will typically involve members such as:
Many of the tasks will involve a coordination of efforts among members of the team. For example, an examination of any patents involved in the acquisition might require the attention of (1) legal counsel, who will evaluate the strength of the patents and their level of transferability to management’s intended purposes; (2) a valuation advisor, who will analyze the patents’ ability to
Step 3. Preparing and executing the preliminary investigation. Management will work with the team members to identify issues that require prompt attention. These will typically be the issues that will affect management’s decision to proceed with the acquisition, and at what price. The plan should be broad and relatively shallow, with enough coverage of the company’s operating, legal and financial characteristics to enable the team members to identify areas that require more detailed procedures. The goal of this preliminary investigation is to identify deal-breaking issues before money and other resources (i.e., management’s time and attention) are committed to a detailed due diligence study. Examples of problems that may be serious enough for the acquirer to consider abandoning the acquisition include:
Step 4. Preparing and executing the detailed due diligence plan. After completing Step 3, management should reconvene with the other team members and solicit recommendations regarding detailed due diligence procedures. At this point, there should be a reasonable level of comfort that the acquisition is feasible and has a reasonable chance of achieving corporate goals. After reflecting on and discussing these recommendations, management should work with the team members to create a detailed plan of action.
The plan should be designed to ensure that, by the time the investigation is completed, everyone thoroughly understands the important issues and unnecessary or duplicated effort is kept to a minimum. It should be written in outline form so each task is distinct, clearly identifiable and assignable to one team member. This allows for personal accountability and ensures that nothing goes undone.
It is also a good idea to clearly identify the questions that will be answered upon completion of each task. The answer to each question should affect:
If the answer to a question does not address one or more of these issues, then perhaps the underlying task is unnecessary or needs to be modified.
Management is charged with the responsibility of coordinating the efforts of the due diligence process and will require ongoing communication with each team member to ensure smooth and timely progress. Also, while the team members should be encouraged to make recommendations based on information discovered through the process, it is ultimately management’s responsibility to make key decisions based on such information.
The Detailed Due Diligence Investigation
An abbreviated checklist of issues which will likely need to be addressed during the detailed investigation (Step 4) includes:
Research and Development (R&D)
Not all of the above issues will be pertinent in every circumstance and many issues not listed above may deserve consideration as well. Each due diligence plan must be tailored to the specific circumstances of the subject company. If a one-size-fits-all approach is employed, the acquirer runs a significant risk of doing too little (and exposing itself to otherwise avoidable problems) or doing too much (and incurring more expense than necessary). In fact, it is quite possible to do both.
Responding to Issues Raised in the Due Diligence Process
The conclusion of the due diligence process is not the time for “buyer’s remorse,” where unwarranted attention is paid to the insignificant weaknesses that invariably exist in any business. Rather, it is the time to constructively deal with issues that can realistically be overcome. Depending on the nature of these issues, the acquirer can often take steps to minimize future exposure to problems and their consequences. Such steps may include:
Due Diligence is an Essential Stage
It is critical to understand that due diligence is an essential part of any well-executed acquisition process. Due diligence is a structured, systematic research effort used to accumulate the facts necessary to make an informed decision regarding an acquisition candidate, thereby increasing the chances of the acquisition’s success (both during and after the transaction). The process is not mysterious or unfathomable, although it may at first seem confusing. Due diligence should not (and, indeed, cannot) simply be delegated to outside professionals, although these professionals will certainly contribute to management’s ability to carry it out. By working together, management and its advisors can timely and efficiently identify and execute those due diligence procedures that will most improve the likelihood that the acquisition will achieve the goals desired by the acquirer.