|
Excerpt from Kensington Services, Inc. – M&A Newsletter, January 2009
Oak Brook, Illinois
Due Diligence Issues
Interview with John Savela CPA, MBA, FCPA
by David P. Leonhardt, CPA, CM&AA
Q: One of your areas of expertise is due diligence as it relates to buying or selling a
business. What is due diligence?
Due diligence, in this instance, refers to the investigation that is necessary to determine
the implication of a proposed transaction to purchase or sell a business, or to merge two
businesses.
Q: What do you investigate?
It depends on which party we’re representing and the type of transaction we’re
investigating. Although the goal is the same, the due diligence process is different and
greatly expanded when dealing with a purchase, sale, or merger of a publicly traded or
multi-national business. Let’s discuss this in terms of a transaction to purchase a small to mid-sized company. We investigate it from a financial, legal, cultural, organizational and operational point of view. No matter which area is investigated, we must get a thorough understanding of the company and the industry through interviews and research. The due diligence process is different for each engagement.
Q: Lets start with financial and legal due diligence.
In order to perform a thorough investigation, the due diligence team must have a
thorough understanding of the business they are investigating and access to all pertinent records. Financially, we want to uncover the true financial condition of the business. Are there any errors in their financial statements? Are there any inconsistencies in their books and records? Are there any inconsistencies or inappropriate treatment of items or transactions which skew the company’s financial position? Does the company own the assets they purport to own? Do the assets currently need replacing, and if not, when? From a financial and legal point of view, we look to discover any undisclosed or potential liabilities arising out of prior transactions or existing contracts and agreements. Are there any improperly recorded liabilities? Are accruals adequate? Are there any potential federal, state or local tax liabilities? Potential liabilities, depending upon the type of business, may include product liability suits, warranties, licensing agreements, or breach of employment agreements. The attorneys will generally do a review of public records and UCC filings relating to the company and its current owners. Are there any currently pending lawsuits? Are there any undisclosed secured borrowings, liens or other judgments against the company?
Q: What is cultural, organizational and operational due diligence?
Whereas the financial and legal due diligence processes analyze the books and records, cultural, organizational and operational due diligence look at the nonfinancial issues which impact the ultimate success of a proposed transaction – financial and nonfinancial.
Q: You could probably instruct a day-long seminar reviewing this part of due diligence.
What are some of the main points in these areas of due diligence?
You could generally summarize these with three concepts – people, processes or systems, and markets. There are many areas to uncover with each concept, and as I stated earlier, these areas are different with each engagement. When it comes to people, we look at management and key employees. Do we retain management or bring in new people? Are the management styles of the two companies compatible? Can they be blended? What will happen to the existing workforce? Are the policies and/or compensation packages compatible with existing policies and compensation? Will there be a mass exodus of personnel? As for processes, the buyer should look at the company’s business plans and models. Are they compatible with the purchaser’s plans and models? Will they achieve desired goals? Are there efficient policies and systems in place to allow for the desired results and growth – purchasing, production, marketing, sales, R&D, and informational, to name a few. As for the markets, what’s the potential for future revenues? Is there a growing or shrinking market for the goods or services? Are forecasts reasonable? Based upon bad assumptions? What about the raw materials or goods and services needed to maintain or expand the business? Are there any indications that the prices will increase greater than forecasted? Is there a potential for material shortages? What about the labor market – will current trends or forecasts effect the company’s or industry’s workforce?
Q: That’s a lot to look into. What about due diligence from the seller’s point of view –
what are some of the issues?
The amount of time the seller spends on due diligence is less than the buyer, but the
importance is the same. The seller’s due diligence team provides the information requested by the purchaser’s due diligence team. The seller’s team may have to defend
its accounting practices or methods. They may also have to defend or negotiate the valuation of assets, such as inventory and receivables or which party will be responsible
for accruals and other perceived discretionary expenses. The seller’s team must review
drafts of the purchase/sales agreements and all other documents relating to the transaction. Is the transaction a stock sale or asset sale? How is the seller getting paid – with cash or with a note? Does the purchaser have the wherewithal to pay? Is the buyer reliable? Are any contingent payment calculations reasonable? Is the seller receiving stock? Are there any restrictions on the stock? If the purchaser wants to make an IRC 338 election, the seller’s due diligence team must make certain the seller is made whole.
Q: Can you share any experiences or problems you’ve uncovered during a due diligence engagement?
There have been many problems, but they all get resolved through negotiation of price or cancellation of the deal. One recent merger engagement had, and still has unresolved issues. The surviving company has inadequate accounting records, and we’ve documented their inability to record and collect their receivables. There are major
industry-specific billing issues relating to billing governmental agencies. They also lack
inventory controls. We’ve discovered additional unrecorded debt. Finally, the two parties cannot agree as to which one will run the business from an operational point of view. The deal is on hold until all of these issues are resolved.
David P. Leonhardt, CPA, CM&AA
With more than 16 years of experience, David Leonhardt provides tax consulting services, including
compliance, planning and research, as well as a wide range of accounting services, including software
implementation and write-up, for clients in the retail, real estate and services industries..
John L. Savela, CPA, MBA, FCPA
With nearly three decades as a practicing CPA, John Savela brings diverse experience with clients in the
real estate (residential and commercial properties), manufacturing, construction, retail and professional
services industries. His expertise includes forensic accounting, litigation support and due diligence services.
Mr. Leonhardt and Mr. Savela can be reached at
Brown CPA Group, Ltd., Northbrook, Illinois
847.509.4100
|
