Due diligence is critical in mergers and acquisitions

August 30, 2016|Brad Kussow

Growth is a key factor in every company’s long-term survival, and mergers and acquisitions can provide exceptional opportunities for growth.

However, struggling businesses looking for a potential buyer could be motivated to overstate sales and report artificially low costs in an effort to enhance their bargaining position. To minimize your risk as a potential buyer, due diligence (which includes determining the reliability of a target company’s financial statements) is now more important than ever. You also need a clear understanding of the key factors driving the business.

You need to be as comfortable as possible that there will be no unpleasant surprises after you close the transaction. With appropriate due diligence, the risk decreases that unknown issues and skeletons in the closet will result in the deal being more expensive than you expected. Be prepared to commit the time and resources you will need for due diligence and integration.

Due diligence forms the basis for identifying potential risks, understanding the target business, and providing improved analysis and decision making. This means identifying potential red flags, focusing on key areas, and taking an objective point of view. A professional due diligence advisor can help you to better accomplish these tasks and increase your odds of post-merger success.

Due diligence analyzes many areas of a target company

Let value be your guide for due diligence. Because every deal is different, it is vitally important to dig deep into areas that have an impact on value, taking care to not get lost in the details and lose track of the big picture. A few key areas of focus are the following:

  • Quality of earnings, working capital and business trends
  • Tax structuring and valuing the transaction
  • Purchase price mechanisms and important definitions
  • Understand financial covenants and credit agreements
  • Identify operational and capital expenditure requirements
  • Industry trends and customer concentrations
  • Financial statement impact and conformity of accounting principles (such as inventory valuation)
  • Employment matters
  • International and start-up operations

Common red flags should get your attention

Although every deal is different, beware of the following:

  • Loss of focus on the core business
  • Only the CEO or an influential manager believes in the deal
  • Cultural considerations are given only a perfunctory review
  • Synergies focus on revenue enhancement (without identifying cost savings)
  • Underestimating the time and resources needed for due diligence and integration
  • Lack of appropriate infrastructure to meet your expectations after the acquisition
  • Customer and supplier concentrations
  • Lack of deal experience and outside expertise
  • The limit price increases during bidding, with numerous bidders
  • Emphasis on how much time, money or reputation has already been sunk into the deal, “forcing” the deal to close

Use experienced and trusted business advisors

Build a network of trusted business advisors who will focus on the long haul and provide objective recommendations. This will go far toward avoiding the conflict-of-interest bias inherent in trusting an executive sponsor who is also in charge of due diligence. You must get external analysis and input to evaluate the deal.

Although it is possible to handle due diligence internally, it can be taxing on your senior management and respective finance teams. Phases that may have taken three to four months a few years ago could now take double that time. Due diligence professionals also help manage the peaks in the process, allowing your senior managers to handle important deal issues and plan the integration while they run your business and avoid deal fatigue. Due diligence professionals will supplement your team, make the entire process more efficient and effective, and let you focus on issues after the close.

Acquisitions are a great way to grow your business. To increase your odds for success and growth and make better decisions, please contact us about appropriate due diligence.

Brad Kussow, CPA, CMA, Shareholder, has nearly 20 years of public accounting, corporate finance, investment banking and consulting experience. He specializes in planning and executing buy-side and sell-side due diligence projects, financial modeling, valuation and working capital analysis.