In our experience, approximately one-third of due diligence investigations uncover serious problems — potential deal breakers. Of those, approximately half fail to complete the merger/acquisition process. It’s crucial that, when conducting due diligence, organizations consider all aspects — strategic, financial, operational, IT, and human capital — to assure a successful transaction. Those who ignore the past are doomed to repeat it. Those who fail to look toward the future may fare similarly.
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By Craig Thornton & Dan Ruskin
Universal Advisor, 2004 Issue No. 3
Although due diligence is routinely performed when acquiring or selling a business, it’s often conducted too quickly or too narrowly, focusing on how a company has historically performed financially. In other words, businesses focus on the past rather than the future of the combined companies.
Traditional financial, legal, and environmental due diligence is crucial to the success of any acquisition; however, we’ve found it insufficient in predicting the long-term success of a transaction. Instead we recommend a multidisciplinary approach. In addition to financial due diligence, businesses should focus on four other, sometimes neglected, areas of due diligence: strategy, information technology (IT), operations, and human capital, including the organization’s culture.
Strategic Due Diligence
Strategic due diligence considers an acquisition in the context of its industry and asks a simple question: Does it make sense — will the acquisition benefit the organization?
For example, for a manufacturing company, how is the organization positioned within their customers’ supply chain? What does it currently manufacture? Who does it sell to? What do you know about the customers? This is key — it’s possible that a seemingly flourishing company could be 12 months away from going out of business because their customers are shifting their supply base from North America to a low cost region. No matter how well a company performs, if the products a company manufactures are at risk, there’s no reason to continue with the acquisition.
Optimally, this is the first step in the due diligence process. Strategic due diligence will provide the acquiring organizations the information to drive change and improve profitability or help the buyer determine that the deal is not worth pursuing.
Financial Due Diligence
Financial due diligence analyzes, qualitatively and quantitatively, how an organization has performed financially to get a sense of earnings on a normalized basis. It’s crucial to look at the anticipated performance of a business as represented by the seller, look at the underlying assumptions they’ve used in preparing their projections, and ensure they’re reasonable and objective. Often times, companies can understand the future by understanding the past — it’s important to assure a plausible bridge can be built to meet the metrics the seller claims may be achieved going forward.
In addition, financial due diligence analyzes the assets and liabilities to be acquired. For example, is the pricing for raw materials on par with market value? Are there finished goods in stock that are unlikely to be sold within the next three to six months? Regarding liabilities, it’s important to acquire only the liabilities that have been incurred by the seller for purchases of inventory or services that occurred prior to the closing date. You don’t want liabilities to appear later on and wonder, “Where did they come from?”
Finally, financial due diligence will look at whether federal and state taxes have been filed appropriately by the seller. Does the seller have nexus in other states? Do they file in those states? It’s important to ensure the seller has complied with all tax requirements.
Operational Due Diligence
Operational due diligence looks at a transaction to determine what the buyer can do to realize improvements in productivity and profitability. This includes examining work centers, material flow, scrap generation, and inventory levels — in short, employing Lean manufacturing principles to achieve maximum profitability.
A purchase price based on a multiple of earnings may include certain operational inefficiencies. Operational due diligence will define this potential along with the cost of implementing the efficiency improvements for the buyer.
Likewise the seller can benefit from operational due diligence by identifying and implementing the changes necessary to increase EBITDA and increasing the multiples due to lower risk.
IT Due Diligence
IT due diligence considers questions such as: What’s the current level of technology? Is it up to date? How well does the company use the existing technology? Is it sufficient to allow the organization to continue to grow? How much money will the buyer need to invest to provide the company with the tools it needs to operate effectively?
Technology in a key component of merger and acquisition activities; it’s imperative to look at IT considerations early in the acquisition process. Careful planning early in the transaction greatly simplifies the post-merger integration of information systems.
Human Capital Due Diligence
When an acquisition fails, it’s frequently due to people or related issues. Key managers and scarce talent leave unexpectedly. Valuable operating synergies evaporate because cultural differences between companies aren’t understood or are simply ignored. Cuts in pay or benefits programs create ill will, which reduces productivity. Management doesn’t communicate its business rationale or its goals for the new company, and staff flounder in the ensuring confusion.
75 percent of all mergers and acquisitions fail to live up to expectations; this is often due to lack of an effective integration plan. It’s crucial to consider staffing issues up front; otherwise, organizations often find themselves dealing with a quagmire of issues that could have been avoided.
Look Toward the Future