Article: 10 principals to follow while conducting Due Diligence

30 March 2017

Due diligence is an investigation that is performed during a phase of euphoric sensation and urgency to expedite the "technical" side of the transaction and move forward to the "doing business" side of the transaction.  

This sense of elation is intensified when the investment bankers enter the picture due to their optimistic nature, and their urge to close the deal.  As a result of this unique environment, the importance of the due diligence is enhanced. The due diligence's purpose is to identify both risks and rewards of the transaction, laying the foundations for the transaction's valuation. The sellers are also overjoyed (has any one ever seen a profitless business plan?).

Therefore, the following are the ten principles for performing due diligence. In the first part we will address the financial, economic and accounting issues involved in the due diligence. In the second part we will address human factors needed to be deeply examine especially when a large transaction is tailored and the company or seller are located in areas where Corporate Governance are in different levels than expected.

 

Part one

1. Do not let the euphoria confuse you – It is imperative that the investigator ignores the elation associated with the transaction and thoroughly examines the financial forecasts upon which the valuation was determined, ruling out any unrealistic or unattainable assumptions. Further the assessment should evaluate whether the company has the tools and capital to operate and finance the planned expansion.

2. Due diligence differs from general audit work and examines beyond the scope of validating financial data. A correctly performed due diligence process assesses the company's current and future businesses operations, while confirming that it is in line with all aspects of the organization's strategy plans including sales and marketing, human resources, and legal matters. The old due diligence method was to execute an additional audit on the financial statements. This especially took place when the examined company was audited by a big accounting firm that was renowned for its audit work and has proper quality control processes. The purpose of the audit of the financial statements is to verify the accuracy of the information and figures included in the financial statements, focusing on past results and after realization. Due diligence focuses not only on finding an explanation for the figures in the financial statements but also on the figures' impact on the company's future business and financial position. The purpose of the due diligence investigation is answer to several key questions. Only some of these answers are found in the company's financial statements.

  • In light of the examination, does the agreed price reflect the company's current and potential position? It is important to distinguish between the company's value when selling to a "regular" acquirer and the company's value when selling to a "specific" acquirer that could provide synergies and benefits that can be achieved on the day after the transaction. The difference between these two values (the premium paid by the "specific" acquirer) should be validated and examined in terms of its probability of being realized and its expected duration to achieve such synergies.  
  • Is the acquiring company able to absorb the (selling) company in terms of working capital, investment in equipment and property, financing capability and repayment of debts?
  • Has the acquirer identified any issues or risks that are red lines on his/her behalf? (These matters are known as walk away issues, noting that once discovered it is time to leave the negotiating table and to withdraw from the deal.)
  • Has the acquirer appropriately assessed the price or the execution of the transaction? Has the acquirer taken into consideration all immediate operational, marketing, strategy, and financing matters associated the transition?
  • Do the company's forecasts factor in tax exposures that may disrupt future cash flows and that may significantly reduce the value of the acquired company?

3. Take the time necessary to complete the job. We all hear of stories about exotic transactions of billionaires keen to get a foothold in the Israeli market. Some even close the deal by signing on a napkin during a quick business meeting in a café. However, most of us do not hear the end of the story that results in drawn out expensive legal cases. The duration should be a balance between the parties' desires to reach a final decision (whether to complete the transaction) and the seller's NO SHOP duration (length of time the seller is prevented from fulfilling parallel sale). In rare cases there is a business constraint that requires completion of a review process within a limited number of days, it is crucial to plan the work properly. The plan should include a clear lay out of what is being examined and the scope of it. Further you should verify that you have ample staff to carry out the task.

4. Ask "what exactly is being acquired?" Focus your examination and identification of the risks of that asset. In many cases an acquisition of a company embodies purchase of a specific component of the company that is valuable to the acquirer or to any other person or organization. For example, an acquisition of IP, an acquisition of development capabilities, an acquisition of production lines to increase production capacity, distribution channels, customer base and so on. In many cases, once the due diligence process begins, the teams are eager to review the usual matters, as part of the overall examination, however, specific issues, for which the transaction was executed, often remain without treatment at all or are dealt with last minute (in the  best case scenario). In the case of an acquisition when IP is at the heart of the matter, it is important to make a distinction between the different types of IP, whether patent, trademark, copyright, trade secret, or business know-how. It is important to examine the IP's registration and legal status or any other protective measure associated. What's expiration date of the assets? What is required in order to complete registration? What is required to continue the protection of these assets? What are the associated expenses? It is also advised to match between the types of intellectual property listed above and the principles of the company's business plan and its revenue forecast. This comparison can illuminate whether a company boasts about its IP but not reflected significantly in revenue. Or alternatively it could detect the IP with the most significant contribution to revenue (consequently the most significant contribution to the value of the acquired company), further refine its inspection regarding this property, obtain a higher level of assurance, and avoid "surprises" down the road. Another example: Sometimes a company acquires another company with the intention of entering new markets and territories. Therefore, the review process must place emphasis on issues which usually do not receive special consideration in the due diligence such as the analyzing the geographic distribution of the acquired operations and researching the market and regulation of these territories in order to achieve a basic understanding of the risks and costs associated with the activity of in these territories, the degree of compatibility of the producing or distributing goods in these territories, and the defense precautions needed upon entering the market  sale in order to not adversely affect the operations with these entities.

 

5. Distinguish between on-going issues and daily issues. Due diligence examines the business operations of the acquired company during the past few years (mainly through analyzing the company's income statement) to fully understand the company's representative profit in the past and the near future. This analysis is considered "on-going" and there no reason to examine this on a monthly basis, or even quarterly basis. However, balance sheet items that are part of the working capital are subject to change within a range of days and could negatively shift the value of the transaction. Account receivables, account payables, inventory, and operating line of credit are usually are usually an integral part of the transaction included in the acquired company. These items can be easily manipulated could interfere with assessment of the business potential of the acquired company as a stand-alone and as a newly owned business company.  For an example:

  • Accounts receivable can be liquidated via factoring diminishing profitability
  • Account payables can be withdrawn on the evening of the transaction date in order to keep large cash balance leaving the company with debt to the new ownership.
  • Inventory balance listed in the books can be quickly realized, at a significant discount, prior to the transaction. This is when the cash balance is not included in the transaction and may be exercised by the owner.
  • Inventory balances that are sold but not yet delivered to the customer however is included in the Company's sales.
  • Seasonality – to determine a stable working capital with regard to seasonality and adjusting it to the date of the transaction.

6. Fully understand the Company's business environment – The Company's business and the industry in which it operates go hand in hand. We can assume that over time the company will outperform the industry. Take note that there is an information gap between the acquirer and acquired company therefore it should be assumed that part of the reasons to sell or to bring in an investor and reduce their share in the company will be derived this information gap.  Therefore, it is important to research the relevant industry and the general business environment in order to understand the company's worst case scenarios.

7. Make sure that there is full synchronization with legal advisors- In parallel to carrying out financial, accounting, and business due diligence, a legal due diligence is also executed. Legal exposures have economic implications that are required to take into account when carrying out a due diligence.

 

Part 2- Human factors

8. Talk to people and hear their opinions of the examined company - If possible under confidentiality agreement, you should conduct informal conversations with the company's customers and suppliers. This non-filtered information reflects the Company's daily operation and will differentiate between artificial and real representation. Sometime, during a deep level DD we are asked and provide a service (using our BDO Intelligence unit) to revile critical information that is not easy to find on key issues or key persons. This information can sometime be a "deal breaker" and having it before closing the deal can save a lot of resources you will need to spend after.

9. Cooperation and transparency on the part of the seller – There is no clear warning sign regarding a lack of cooperation or transparency of the seller. Deceptions, such as the slow transfer of materials, the transfer of partial information, the transfer of a surplus of information, and the transfer of inconsistent information, are red flags which indicate not only the risk level but also the nature of the future business relationship. It is clear to both parties that in order to achieve full cooperation and maximum transparency on the part of the seller, it is required to keep all information confidential.

10. Evaluate the quality of corporate governance in the acquired company - This topic has been gaining importance, especially for large transactions, transactions associated with a public companies or financial institutions, and global transactions in developed markets, especially the United States. This trend has been increasingly utilized as a measure to minimize officers' and directors' risk-taking when executing transactions. The expansion of responsibility for these officers has led to growing importance to examine the following issues in the acquired company:

 

  • Compliance and quality provisions applicable to the acquired company. In many countries it is required to meet regulations in terms of the corporation (Corporations Act - law that regulates the corporate law in Israel) and of the public (e.g. Securities Act). In stricter countries, such as the United States, it may be required to comply with the federal regulation, municipality regulation, or even industry (insurance, banking, medicine, food, etc.) regulation.
  • Existence and independence of bodies or organizations responsible of the supervision of management, Board of Directors, internal auditor, etc.
  • Existence and independence of the committees' unique to sensitive issues such as, Audit Committee, Financial Statements Committee, Compensation Committee etc.
  • Risk management especially in the areas of environmental protection, worker rights, insider trading, money laundering, organized procurement, and prohibition of bribery in business processes even in countries where it is needed.
  • The company devotes resources to training and supervising of all company employees. Employees are regularly made aware of the expectations of them. These programs (internal compliance programs) are conducted in a variety of subjects.