PRELIMINARY DUE DILIGENCE (This is the 9th article in the series on M&A)

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An extremely important and usually the most critical part of the acquisition process is a well-conducted due diligence. This is not a stage where the financial condition only of the company is thoroughly checked out—far from it. It is a stage when the entire business relates to its operations, supplier relations, customer relations, employee relations, relations with the financial institutions it deals with, its strategy, businessdevelopment plans, and so on as we will see in this and the nex tarticle.

It is rather evident that this process can be a very expensive undertaking. Therefore, it is strongly recommended that the due diligence process is divided in to two stages: the preliminary stage and the formal stage. Basically your goal in preliminary due diligence, once you have obtained enough information to have an understanding that the company meets your criteria, is to determine early in the process whether or not there are any obvious skeletons in the closet—anything of significance hidden from you that could seriously jeopardize the value of the company, whether there is a drop in sales or unanticipated major expenses, any major lawsuits and the like.

This process continues, only with more detail, in the formal due diligence phase once the letter of intent is signed.  Not all explanations of the buying process make the distinction between preliminary and formal due diligence. However, this distinction is essential to carrying out an efficient, affordable yet effective search.

Formal due diligence is very expensive, if done correctly, costing anywhere between $25,000 for a very small company to $100,000 or more, depending upon the size and complexity of the company.  You will quickly run out of money in your search without very carefully prescreening the companies for which you plan to conduct a formal due diligence, even though a lead may meet your broad criteria. Thus, you want to find out as much about a company as you can, asm inexpensively as you can, before you commit to a formal due diligence process.

By contrast, preliminary due diligence primarily costs you your time and travel expenses. You may also need some legal or accounting assistance, depending upon your own background, but it is still far less costly
than when you enter into formal due diligence. By separating preliminary from formal due diligence, you are basically separating out the issues that you can find out about relatively cheaply and
quickly from those that may require extensive investigation and the aid of costly consulting services.  JPE Inc. estimated that it will spends an average of only a few thousand dollars in exploring each lead during preliminary due diligence, relying primarily on its own salaried employees for legal and accounting in-house.

 

Typically, you can expect to narrow down your lead pool from about twenty-five  or thirty to about eight or ten companies over a two-year period that pass the screen of the preliminary due diligence filter, and for which you actually prepare a letter of intent. Of those, you still might only carry out formal due diligence for four or five companies or perhaps even fewer until you find the correct company to buy if you follow the procedures outlined here.

 

This article reviews the third stage of the filtering process of your lead flow that we refer to as preliminary due diligence.

Definition of Due Diligence

Due diligence is the careful, thorough evaluation of a company that you carry out to properly assess its value to you and also to uncover any potentially damaging issues that may cost you money after the sale i closed. Quite literally, due diligence is the care and caution in investigating the seller’s company.  If you are a publicly held company, due diligence has legal implications.  You are expected to investigate certain
aspects of a purchase before spending shareholder money to close the deal.  But well beyond the legal requirements and even if all the money you are spending is your own, it is critical that you evaluate a company thoroughly before buying it.

Because of its high expense, conducting a formal due diligence for more than a few companies in your search becomes highly impractical.  Preliminary due diligence is simply the first step in due diligence, which you can carry out relatively affordably and primarily with your own efforts before you investigate the company in such exhaustive detail.  You should define your own plan for preliminary due diligence so that you can keep the overall costs of the sale to a reasonable level. Select among the evaluation criteria those that you or any salaried personnel can do initially yourselves before hiring expensive outside consultants.

When Preliminary Due Diligence Occurs

The timing of preliminary due diligence is slightly different depending upon the broker involved in the sale.  In the case of the deal represented by the investment banker, preliminary due diligence refers to the evaluation of the company that takes place after the letter of interest is accepted and before the letter of intent is signed.

In the case of the deal represented by buyer-brokers, both the professional broker and intermediary, you are not likely to sign a letter of interest. Thus, the onset of preliminary due diligence is a little less precise. But generally speaking, it is the investigation you carry out after having signed the confidentiality agreement, the receiving of initial information, and  the decision to pursue the lead before you sign a letter of intent.

The letter of intent is an important milestone ending the preliminary due diligence.  Once the letter of intent is signed, you are often committed to carry out formal due diligence and to close the deal within a set time frame and/or to pay a break-up fee if you decide not to go through with the deal.  At the same time, until you sign a letter of intent, you are not protected should the seller decide to sell the company to someone else.  Thus, by its very nature, preliminary due diligence needs to be low cost because you lack exclusivity protection during this period, i.e., the seller can always go with another buyer.

 

The Goals of Preliminary Due Diligence

Ideally, you want to accomplish the following key goals of the preliminary due diligence:

1.   To determine whether the seller is really serious about selling the company and if so, why does he or she want to sell it

2.   To determine whether this is the company that you want to buy

3.   To determine the price do you want to offer to the seller for the company in your letter of intent

4.   To develop rapport with the seller and

5. To uncover any red flags that suggest you should abandon this lead.

Goal 1: To determine whether the seller is really serious about selling the company and if so, why does he or she want to sell it:  In the case of the seller represented by an investment banker, you can assume that the seller is serious about selling. He or she has typically already spent a part of the fee to the investment banker for the preparation of the memorandum or book that you receive once you sign a confidentiality agreement.  However, in the case of more informal intermediaries, you might run into the seller that has been goaded into meeting with you by a convincing broker and agrees to do so primarily out of idle curiosity. You probably want to weed out such cases because these are the leads most likely to go sour during the long negotiation process and may turn out to be the most expensive deals.

You should also determine the seller’s motive for selling. A thorough understanding of the seller’s motive may lead your due diligence in certain directions that you might not have thought about otherwise.

Goal 2: To determine whether this is the company that you want to buy:  The second goal of preliminary due diligence is a further assessment of the fit of this company to your original business plan.  Obviously, if you run into damaging information during the formal due diligence phase, you might still decide not to buy a company, but you need to sort out at this stage, before you spend a lot of money on formal due diligence. You might still go forward with the deal if this company matches your requirements for size, location, type of product or service, growth rate, profitability, core capabilities, or whatever other criteria you have set up for yourself. But you will want to guard against potential problems by negotiating a price and escrow arrangements in keeping with the perceived risks.   If this company does not match very well with your original acquisition plan, review carefully whether or not you are really interested in this type of company or if you are being pushed forward by the momentum of the lead process.  Even if this company is the type of company you want, is this particular company the right one for you?  Is this a company that has created a successful market niche for itself?

Goal 3: To determine the price that you want to offer to the seller for the company in your letter of intent: Another objective of the preliminary due diligence phase is to determine the purchase price as closely as possible, barring unknown contingencies that might affect the value of the company, which you might still uncover before closing.  The price stated in the letter of intent, although still nonbinding, should be as accurate as possible so that you are sure the seller and you are not too far apart in final negotiations.   Otherwise, you risk the deal going sour after having spent significant time and dollars during the formal due diligence phase.

Of course, before formal due diligence is completed, you cannot know all the contingencies that might affect the final price.  But these unknown costs can be covered by
contingency clauses in the letter of intent that must be resolved in the formal due diligence process prior to closing.

Goal 4: To develop rapport with the seller:   Building rapport with the seller is another very important goal of the preliminary due diligence process.  A seller is not obligated to sell to a particular buyer.  The highest bid does not automatically get the deal.   Many a deal has been made or lost based on the chemistry between buyer and seller.  Chemistry becomes even more important when the seller is needed to stay on to help manage the company and/or is helping to finance the deal in some way. Rapport is important where multiple bidding is involved, as in the case of investment bankers.  It can also be a key factor in the purchase
of the family business, where the owner feels a sense of duty and responsibility to longtime employees who may stay on with the business after it changes to new ownership.

Goal 5:  To uncover any red flags that suggest you should abandon this lead: At any stage of due diligence, you want to uncover potentially damaging problems.   But red flags ascertained during the preliminary due diligence phase could save you the expense of formal due diligence and/or a break-up fee if you decide the problem is serious enough to abandon the deal.  A special section later in this article examines these red flags in more detail.

 

Conducting Preliminary Due Diligence

Preliminary due diligence has three aspects: the company visit, a preliminary review of documents, and a meeting with the seller.  Again, the pattern is somewhat different depending upon the size of company, and in particular, whether or not an investment banker is involved.

The Company Visit

The company visit is a very important aspect of preliminary due diligence. Ideally, you want to make two company visits and to arrange at least part of that time to meet alone with the seller, both to build
rapport and to develop your intuitive sense about the company and its owner.  Be prepared to stay about four to six hours for each visit.  Don’t be disappointed if you are scheduled for a shorter visit, especially if an
investment banker is involved.  But be prepared to stay longer if the owner is interested.  This is an ideal time to get to know the seller, both to build rapport and to learn his or her motives for selling the company.

The first company visit varies in timing, content, and purpose, depending upon the broker involved with the deal.  Let’s take the case, first, of the investment-banker-represented deal. If your letter of interest is accepted, you will be formally scheduled for a visit, at which time managers from the seller’s company make a formal presentation. You will probably meet with several managers of the company in a conference
room.  They will provide an overview of the company that often follows the content of the memorandum quite closely.  For instance, they may describe their market and its growth potential, their manufacturing processes and how they are improving them, their financial condition, and other basic information about the organization.  Quite often, the investment banker has assisted in preparing the presentation so it is quite
polished.  Following the presentation, the buyer has the opportunity to ask questions then to take a plant tour and afterward to return to the conference room for additional discussion.

Even if the investment banker generally stays fairly close by the seller during this visit, you will find it helpful to try to steal as many moments alone with the seller as you can, in order to begin developing some rapport with him or her.  Personal contact time with the seller is very useful because it develops your intuitive or physical sensing of the seller—how trustworthy he or she is and whether or not he is telling the truth.  You can also be more persuasive in face-to-face contact than you could in a letter to the seller.  Face-to-face contact is simply a richer medium for information than written documentation.  For adequate face-to-face contact to occur, you often have to arrange for a second company visit.  A second visit also indicates your strong interest, which may be beneficial in a situation where you are competing with other buyers In other settings where the investment banker is not involved, the first visit is likely to be much less formal.  When the investment banker is not involved, you may simply chat with the owner in his office and take a tour of the plant.

Regardless of the type of broker involved, you want to try to have the opportunity to share your background as well so that the owner begins to gain confidence in you as the buyer. This is a very important aspect of the procedure followed at JPE Inc.

 

Review of Documentation During the Preliminary Due Diligence Phase

You begin review of company documentation during the preliminary due diligence phase.

Review of documentation when an investment banker is involved:  Review of documentation during the preliminary due diligence is likely to be much more formalized where an investment banker is involved.  In that instance, either at the first company visit or within the following few weeks, the seller will have prepared a due diligence room where they keep all the paperwork they think you might be interested in.

Remember at this stage, there are still five or six other prospective buyers. You are not going to be allowed to speak with suppliers, customers, or employees other than a few key managers.  Thus, most of your information will be culled from the company visit, the documentation, and your general knowledge of the industry. (For instance, if you are a competitor, supplier, or customer for the same industry, you may already know what the customers think of this company.)

The documentation is likely to be wide-ranging including financial statements, benefits package information, including health or pension funds, reports they have done on environmental work, internal revenue service records, and basically, anything else you find in paperwork form.  Sometimes the investment banker would like you to do more work at this stage in the proceedings than is really necessary.  Remember that sifting through thousands of pages of documentation is costly, especially if you need outside help. But you do want to peruse the documentation sufficiently so that you are satisfied that there are no serious red flags you can spot right away.

Review of documentation when a buyer-broker is involved: Preliminary due diligence, especially this aspect, is much more difficult when the buyer-broker is involved because there is no book or memorandum repared.  Nor is there likely to be a due diligence room set up with all the documentation in one place.  No one has gathered the information, and you are likely to need at least three people involved—an accountant, a lawyer, and a financial auditor to help with the preliminary due diligence to assist with determining the appropriate price and to draft the letter of intent.   Typically at the preliminary due diligence, even when an informal intermediary is involved, you will want to ask for a variety of readily available documents.  You usually want to ask for union contracts, any documents related to the American Disabilities Act, any benefits documentation, group medical health, pension plans, 401 (k) plans, or other employee related contracts. You also ask to have copies of any Environmental Protection Agency studies that have been done.  You will want to get financial information for the past several years as well as any projections that might be available.  You may only scan much of the material at this stage, but it is helpful to begin to gather and review this material anyway.

 

Meeting with the Seller

You may be able to meet with the seller as a part of
your first company visit.  If not, it is
important to try to set up some time when you can meet alone with the seller.
Although when an investment banker is involved, you may have to be persuasive
about this.  There are a few key reasons
you need to meet with the seller early on.
First of all, as mentioned earlier, you want to know whether he is a
willing and serious seller. You don’t want to waste a lot of time if he’s not
really planning to sell.  Secondly, if he
or she is serious, what is the price that he or she has in mind? Sometimes you
can come right out and ask the investment banker. They won’t tell you directly,
but they will often tell you the high side of the range.  Or the seller may tell you.   Thirdly, if the seller is willing, you want
to determine whether you are dealing with a reasonable person.  You may have to follow your intuition on this
one although it is a good sign if he has professional advisors.  Fourth, does the seller have partners, and if
so, are they influential in the sale?
You don’t want to waste your time convincing one partner to sell only to
find out that other partners have been excluded from important
conversation.  If partners are not
actively participating in the discussion, will they rely on his decision?  You may want to try to verify this
independently if you can.  Finally, you
want to find out why the seller wants to sell.
If it is to settle an estate, or he is getting older and plans to
retire, then these are pretty good reasons.

One of the red flags to watch for at this stage is
whether or not the owner has lost his or her competitive edge. One sign of this
might be that they talk a lot about competition, in the manner that it is
almost a fixation.  Another is how
recently they have been involved with development of new product.  This is a problem because companies can fall
quickly behind their competitors when led by such an owner and may have a
difficult time catching up.  He may have
stopped managing the company for the future.
A second red flag is that the seller is strictly motivated by price
alone (and won’t sell unless the price is high enough).  These are situations, as mentioned early,
where the seller may not be motivated enough to complete the sale.

 

Type of Information You Are Likely to Collect During PRELIMINARY
DUE DILIGENCE

 

An extremely important and usually the most critical
part of the acquisition process is a well-conducted due diligence. This is not
a stage where the financial condition only of the company is thoroughly checked
out—far from it. It is a stage when the entire business relates to its
operations, supplier relations, customer relations, employee relations,
relations with the financial institutions it deals with, its strategy, business
development plans, and so on as we will see in this and the next article.

It is rather evident that this process can be a very
expensive undertaking. Therefore, it is strongly recommended that the due
diligence process is divided in to two stages: the preliminary stage and the
formal stage. Basically your goal in preliminary due diligence, once you have
obtained enough information to have an understanding that the company meets
your criteria, is to determine early in the process whether or not there are
any obvious skeletons in the closet—anything of significance hidden from you
that could seriously jeopardize the value of the company, whether there is a
drop in sales or unanticipated major expenses, any major lawsuits and the
like.

This process continues, only with more detail, in the
formal due diligence phase once the letter of intent is signed.  Not all explanations of the buying process
make the distinction between preliminary and formal due diligence. However,
this distinction is essential to carrying out an efficient, affordable yet
effective search.

Formal due diligence is very expensive, if done
correctly, costing anywhere between $25,000 for a very small company to
$100,000 or more, depending upon the size and complexity of the company.  You will quickly run out of money in your
search without very carefully prescreening the companies for which you plan to
conduct a formal due diligence, even though a lead may meet your broad
criteria. Thus, you want to find out as much about a company as you can, as
inexpensively as you can, before you commit to a formal due diligence process.

By contrast, preliminary due diligence primarily costs
you your time and travel expenses. You may also need some legal or accounting
assistance, depending upon your own background, but it is still far less costly
than when you enter into formal due diligence.
By separating preliminary from formal due diligence, you are basically
separating out the issues that you can find out about relatively cheaply and
quickly from those that may require extensive investigation and the aid of
costly consulting services.  JPE Inc.
estimates that it spends an average of only a few thousand dollars in exploring
each lead during preliminary due diligence, relying primarily on its own
salaried employees for legal and accounting in-house.

Typically, you can expect to narrow down your lead pool
from about twenty-five  or thirty to
about eight or ten companies over a two-year period that pass the screen of the
preliminary due diligence filter, and for which you actually prepare a letter
of intent. Of those, you still might only carry out formal due diligence for
four or five companies or perhaps even fewer until you find the correct company
to buy if you follow the procedures outlined here.

This article reviews the third stage of the filtering
process of your lead flow that we refer to as preliminary due diligence.

 

Definition of Due Diligence

Due diligence is the
careful, thorough evaluation of a company that you carry out to properly assess
its value to you and also to uncover any potentially damaging issues that may
cost you money after the sale is closed.
Quite literally, due diligence is the care and caution in investigating
the seller’s company.  If you are a
publicly held company, due diligence has legal implications.  You are expected to investigate certain
aspects of a purchase before spending shareholder money to close the deal.  But well beyond the legal requirements and
even if all the money you are spending is your own, it is critical that you
evaluate a company thoroughly before buying it.

Because of its high expense, conducting a formal due
diligence for more than a few companies in your search becomes highly
impractical.  Preliminary due diligence is simply the first step in due
diligence, which you can carry out relatively affordably and primarily with
your own efforts before you investigate the company in such exhaustive
detail.  You should define your own plan
for preliminary due diligence so that you can keep the overall costs of the
sale to a reasonable level. Select among the evaluation criteria those that you
or any salaried personnel can do initially yourselves before hiring expensive
outside consultants.

When Preliminary Due Diligence Occurs

The timing of preliminary due diligence is slightly
different depending upon the broker involved in the sale.  In the case of the deal represented by the
investment banker, preliminary due diligence refers to the evaluation of the
company that takes place after the letter of interest is accepted and before
the letter of intent is signed.

In the case of the deal represented by buyer-brokers,
both the professional broker and intermediary, you are not likely to sign a
letter of interest. Thus, the onset of preliminary due diligence is a little
less precise. But generally speaking, it is the investigation you carry out
after having signed the confidentiality agreement, the receiving of initial information,
and  the decision to pursue the lead
before you sign a letter of intent.

The letter of intent is an important milestone ending
the preliminary due diligence.  Once the
letter of intent is signed, you are often committed to carry out formal due
diligence and to close the deal within a set time frame and/or to pay a
break-up fee if you decide not to go through with the deal.  At the same time, until you sign a letter of
intent, you are not protected should the seller decide to sell the company to
someone else.  Thus, by its very nature,
preliminary due diligence needs to be low cost because you lack exclusivity
protection during this period, i.e., the seller can always go with another
buyer.

 

The Goals of Preliminary Due Diligence

Ideally, you want to accomplish the following key goals
of the preliminary due diligence:

1.   To determine
whether the seller is really serious about selling the company and if so, why
does he or she want to sell it

2.   To determine
whether this is the company that you want to buy

3.   To determine
the price do you want to offer to the seller for the company in your letter of
intent

4.   To develop
rapport with the seller and

5. To uncover any red flags that suggest you should abandon
this lead.

Goal 1: To determine whether the seller is really
serious about selling the company and if so, why does he or she want to sell it:  In the case of the seller represented by an
investment banker, you can assume that the seller is serious about selling. He
or she has typically already spent a part of the fee to the investment banker
for the preparation of the memorandum or book that you receive once you sign a
confidentiality agreement.  However, in
the case of more informal intermediaries, you might run into the seller that
has been goaded into meeting with you by a convincing broker and agrees to do
so primarily out of idle curiosity. You probably want to weed out such cases
because these are the leads most likely to go sour during the long negotiation
process and may turn out to be the most expensive deals.

You should also determine the seller’s motive for
selling. A thorough understanding of the seller’s motive may lead your due
diligence in certain directions that you might not have thought about
otherwise.

Goal 2: To determine whether this is the company
that you want to buy:  The second goal of preliminary due diligence is a
further assessment of the fit of this company to your original business
plan.  Obviously, if you run into
damaging information during the formal due diligence phase, you might still
decide not to buy a company, but you need to sort out at this stage, before you
spend a lot of money on formal due diligence. You might still go forward with
the deal if this company matches your requirements for size, location, type of
product or service, growth rate, profitability, core capabilities, or whatever
other criteria you have set up for yourself.
But you will want to guard against potential problems by negotiating a
price and escrow arrangements in keeping with the perceived risks.   If this company does not match very well
with your original acquisition plan, review carefully whether or not you are
really interested in this type of company or if you are being pushed forward by
the momentum of the lead process.  Even
if this company is the type of company you want, is this particular company the right one for
you?  Is this a company that has created
a successful market niche for itself?

Goal 3: To determine the price that you want to
offer to the seller for the company in your letter of intent: Another objective of the preliminary due diligence phase is to
determine the purchase price as closely as possible, barring unknown
contingencies that might affect the value of the company, which you might still
uncover before closing.  The price stated
in the letter of intent, although still nonbinding, should be as accurate as
possible so that you are sure the seller and you are not too far apart in final
negotiations.   Otherwise, you risk the
deal going sour after having spent significant time and dollars during the
formal due diligence phase.

Of course, before formal due diligence is completed, you
cannot know all the contingencies that might affect the final price.  But these unknown costs can be covered by
contingency clauses in the letter of intent that must be resolved in the formal
due diligence process prior to closing.

Goal 4: To develop rapport with the seller:   Building rapport with the
seller is another very important goal of the preliminary due diligence process.  A seller is not obligated to sell to a
particular buyer.  The highest bid does
not automatically get the deal.   Many a
deal has been made or lost based on the chemistry between buyer and
seller.  Chemistry becomes even more
important when the seller is needed to stay on to help manage the company
and/or is helping to finance the deal in some way. Rapport is important where
multiple bidding is involved, as in the case of investment bankers.  It can also be a key factor in the purchase
of the family business, where the owner feels a sense of duty and
responsibility to longtime employees who may stay on with the business after it
changes to new ownership.

Goal 5:  To
uncover any red flags that suggest you should abandon this lead: At any stage of due diligence, you want to uncover potentially damaging
problems.   But red flags ascertained
during the preliminary due diligence phase could save you the expense of formal
due diligence and/or a break-up fee if you decide the problem is serious enough
to abandon the deal.  A special section
later in this article examines these red flags in more detail.

 

Conducting Preliminary Due Diligence

 

Preliminary due diligence has three aspects: the company
visit, a preliminary review of documents, and a meeting with the seller.  Again, the pattern is somewhat different
depending upon the size of company, and in particular, whether or not an
investment banker is involved.

The Company Visit

T company visit is a very important aspect of
preliminary due diligence. Ideally, you want to make two company visits and to
arrange at least part of that time to meet alone with the seller, both to build
rapport and to develop your intuitive sense about the company and its
owner.  Be prepared to stay about four to
six hours for each visit.  Don’t be
disappointed if you are scheduled for a shorter visit, especially if an
investment banker is involved.  But be
prepared to stay longer if the owner is interested.  This is an ideal time to get to know the
seller, both to build rapport and to learn his or her motives for selling the
company.

The first company visit varies in timing, content, and
purpose, depending upon the broker involved with the deal.  Let’s take the case, first, of the
investment-banker-represented deal. If your letter of interest is accepted, you
will be formally scheduled for a visit, at which time managers from the
seller’s company make a formal presentation.
You will probably meet with several managers of the company in a conference
room.  They will provide an overview of
the company that often follows the content of the memorandum quite
closely.  For instance, they may describe
their market and its growth potential, their manufacturing processes and how
they are improving them, their financial condition, and other basic information
about the organization.  Quite often, the
investment banker has assisted in preparing the presentation so it is quite
polished.  Following the presentation,
the buyer has the opportunity to ask questions then to take a plant tour and
afterward to return to the conference room for additional discussion.

Even if the investment banker generally stays fairly
close by the seller during this visit, you will find it helpful to try to steal
as many moments alone with the seller as you can, in order to begin developing
some rapport with him or her.  Personal
contact time with the seller is very useful because it develops your intuitive
or physical sensing of the seller—how trustworthy he or she is and whether or
not he is telling the truth.  You can
also be more persuasive in face-to-face contact than you could in a letter to
the seller.  Face-to-face contact is
simply a richer medium for information than written documentation.  For adequate face-to-face contact to occur,
you often have to arrange for a second company visit.  A second visit also indicates your strong
interest, which may be beneficial in a situation where you are competing with
other buyers.

In other settings where the investment banker is not
involved, the first visit is likely to be much less formal.  When the investment banker is not involved,
you may simply chat with the owner in his office and take a tour of the plant.

Regardless of the type of broker involved, you want to
try to have the opportunity to share your background as well so that the owner
begins to gain confidence in you as the buyer.
This is a very important aspect of the procedure followed at JPE
Inc.

Review of Documentation During the Preliminary Due
Diligence Phase

You begin review of company documentation during the
preliminary due diligence phase.

Review
of documentation when an investment banker is involved:  Review of documentation during the
preliminary due diligence is likely to be much more formalized where an
investment banker is involved.  In that
instance, either at the first company visit or within the following few weeks,
the seller will have prepared a due diligence room where they keep all the
paperwork they think you might be interested in.  Remember at this stage, there are still five
or six other prospective buyers. You are not going to be allowed to speak with
suppliers, customers, or employees other than a few key managers.  Thus, most of your information will be culled
from the company visit, the documentation, and your general knowledge of the
industry. (For instance, if you are a competitor, supplier, or customer for the
same industry, you may already know what the customers think of this company.)

The documentation is likely to be wide-ranging including
financial statements, benefits package information, including health or pension
funds, reports they have done on environmental work, internal revenue service
records, and basically, anything else you find in paperwork form.  Sometimes the investment banker would like
you to do more work at this stage in the proceedings than is really
necessary.  Remember that sifting through
thousands of pages of documentation is costly, especially if you need outside
help. But you do want to peruse the documentation sufficiently so that you are
satisfied that there are no serious red flags you can spot right away.

Review
of documentation when a buyer-broker is involved: Preliminary due diligence,
especially this aspect, is much more difficult when the buyer-broker is
involved because there is no book or memorandum prepared.  Nor is there likely to be a due diligence
room set up with all the documentation in one place.  No one has gathered the information, and you
are likely to need at least three people involved—an accountant, a lawyer, and
a financial auditor to help with the preliminary due diligence to assist with
determining the appropriate price and to draft the letter of intent.            Typically
at the preliminary due diligence, even when an informal intermediary is
involved, you will want to ask for a variety of readily available
documents.  You usually want to ask for
union contracts, any documents related to the American Disabilities Act, any
benefits documentation, group medical health, pension plans, 401 (k) plans, or
other employee related contracts. You also ask to have copies of any
Environmental Protection Agency studies that have been done.  You will want to get financial information
for the past several years as well as any projections that might be available.  You may only scan much of the material at
this stage, but it is helpful to begin to gather and review this material
anyway.

Meeting with the Seller

You may be able to meet with the seller as a part of
your first company visit.  If not, it is
important to try to set up some time when you can meet alone with the seller.
Although when an investment banker is involved, you may have to be persuasive
about this.  There are a few key reasons
you need to meet with the seller early on.
First of all, as mentioned earlier, you want to know whether he is a
willing and serious seller. You don’t want to waste a lot of time if he’s not
really planning to sell.  Secondly, if he
or she is serious, what is the price that he or she has in mind? Sometimes you
can come right out and ask the investment banker. They won’t tell you directly,
but they will often tell you the high side of the range.  Or the seller may tell you.   Thirdly, if the seller is willing, you want
to determine whether you are dealing with a reasonable person.  You may have to follow your intuition on this
one although it is a good sign if he has professional advisors.  Fourth, does the seller have partners, and if
so, are they influential in the sale?
You don’t want to waste your time convincing one partner to sell only to
find out that other partners have been excluded from important
conversation.  If partners are not
actively participating in the discussion, will they rely on his decision?  You may want to try to verify this
independently if you can.  Finally, you
want to find out why the seller wants to sell.
If it is to settle an estate, or he is getting older and plans to
retire, then these are pretty good reasons.

One of the red flags to watch for at this stage is
whether or not the owner has lost his or her competitive edge. One sign of this
might be that they talk a lot about competition, in the manner that it is
almost a fixation.  Another is how
recently they have been involved with development of new product.  This is a problem because companies can fall
quickly behind their competitors when led by such an owner and may have a
difficult time catching up.  He may have
stopped managing the company for the future.
A second red flag is that the seller is strictly motivated by price
alone (and won’t sell unless the price is high enough).  These are situations, as mentioned early,
where the seller may not be motivated enough to complete the sale.

 

Preliminary Due Diligence

 

This section highlights some of the issues you are most
likely to investigate at the preliminary due diligence phase. Some of the
issues include the financial condition of the company, marketing data including
sales trends, the union contract, benefits, manufacturing processes, and any
environmental issues.

Financial condition:  You want to
examine the overall profitability of the firm and whether expenses are properly
accounted for on the income statement, rather than being counted as assets. You
want to examine the size of inventory in relationship to overall assets, the
cash flow of the company, sales trends, and overall debt. It is very hard to
acquire a company that is already highly leveraged especially if you plan to
borrow significantly to buy the company.

Marketing data:  You want to
examine the viability of the product or service, first and foremost. If sales
have been flat or downward in recent years, you need to explore the cause of
such trends. But you also need to examine future trends. For instance, does the
company rely too heavily on any one customer, on a product that will become
rapidly obsolete, or is it about to lose a major customer?  Is the company bringing new products on line
in a timely fashion?  Some of these
issues you may be able to determine quickly from the financial data and your knowledge
of the industry.  Others may have to wait
until formal due diligence.

Union contract and benefits:  You may not want
to inherit a company contract that promises costly benefits.  You must also weigh the timing of buying the
company if a major contract is up for renegotiation shortly after you are
likely to close on the deal.   It is a
very difficult situation to face.   You
might want to see if the medical plan is transferable when ownership changes.
In the union contract, in particular, you might want to examine whether
employees are flexible in their job assignments, especially in a manufacturing
setting.  Basically, you look for issues
that might cause you to lose interest or hedge on the price.

Some red flags to look for in this area may be that the
pay is too high, that there are too many classifications, or that the contract
is up for negotiation pretty quickly. It is helpful to get to know your
employees and union before you need to negotiate a contact.  Even if the contract is unfavorable, you are
not likely to be in a position to make major changes, at least not in the short
term.

Manufacturing processes: Again you are not likely to be able to examine issues
in great detail in preliminary due diligence, but a survey of the facilities,
equipment, and grounds can give you a lot of cues about how up-to-date the
equipment is (and thus how costly to replace or modernize, if necessary).  The facilities can also give you some clues
as to employee attitudes and morale—whether things are kept neat, people are at
work or standing around, the demeanor of employees as you pass through the
plant.

Environmental issues:  Environmental impact is another area of
growing importance.  Some larger
companies may have an environmental study recently done and on file. But with
many smaller and older companies, the owner may not even be aware of problems
that exist.  You may or may not discover
some of these problems until the formal due diligence phase.  In the case of one company explored by JPE
Inc., a pollution problem stemmed from underground tanks removed years
earlier.  A concrete slab factory floor
had been built over the original site, making it even more costly to
investigate.  Studies carried out during
formal due diligence eventually revealed that the problem was a relatively
minor one, but the investigation itself was time-consuming and costly.

You should seriously consider dropping a company with
major environmental pollution problems unless it is possible to assess the cost
and extent of cleanup accurately before closing.  Even if the former owner is legally liable,
it is often very difficult to collect from any but the largest corporations
after closing takes place.  If you are
able to assess the probably cost, you can factor the cost into the price or
into an escrow agreement that holds the money for potential cleanup in a
separate account for a designated period after the closing.

Tax implications: Another very important area to investigate during
preliminary due diligence are the tax implications of the sale for the
seller.  Tax laws change overtime.  You need to
investigate early on, with the help of a qualified tax lawyer, what the
tax implications are from the standpoint of both buyer and seller. Sometimes, once a seller looks at his
taxes, he is not so sure he wants to sell his company after all. For instance,
he may net much less money than he counted on for retirement and decide to
continue working instead.

 

Red Flags / Surprises to Watch for During Due Diligence

 

Several red flags are most common to come across during
preliminary or formal due diligence. If the answer to any of the following
questions is yes, you might want to seriously consider discontinuing your
investigation and look for another company with fewer problems:

1.   Does the company
have serious environmental problems, ground, water, or air pollution that might
be costly to rectify?

2. Is there significant labor unrest and/or a labor
contract about to be renegotiated?

3.   Does the owner
have too high expectations about the price?

4.   Is there too
much debt?

5.   Are there
potentially serious product liability issues?

6.   Are there
employee grievances that may lead to a costly lawsuit?

There will be some surprises. Stay calm and collected.
It is not unusual. Look at them, study them, get a clear understanding of what
they are and what they mean to the business. Evaluate them. Do not let the
seller feel that you will walk away from the deal every time you have a
surprise. After all, the negotiating/acquisition process is a series of problem-solving
undertaking. To minimize surprises, be as prepared as you can and be within the
timetable you have. Send the seller a detailed list of what you and your team
want to look at, to review. Do not start the process until you have what you
need to start the process.

 

 Summary

This article reviewed the important step of preliminary
due diligence that takes place once a confidentiality agreement is signed, and
you are satisfied that a lead meets your major criteria.  The preliminary due diligence has three
important aspects: a meeting with the seller, one or two company visits, and a
preliminary review of documentation.

There are four key goals in the preliminary due
diligence phase. They are the following:

1.   To determine
whether this company is what you want to buy (barring any unexpected
“skeletons” you might uncover during formal due diligence)

2.   To determine
the price you want to offer in your letter of intent

3.   To determine
whether the seller is serious about selling and why

4.   To develop
rapport with the seller

There is a variety of information, which you can gather
at this stage without spending a lot of money by reviewing available
documentation and visiting the company.
During preliminary due diligence, you want to get an overall sense of
the company’s financial condition, marketing and sales, employee practices,
manufacturing processes, and very important but sometimes overlooked,
environmental issues.  Basically, you
inherit any potential liabilities that are buried in the information that the
seller provides. And if the seller lacks deep pockets, you can still be sued
for problems that you inherited but did not cause. The earlier you surface
those skeletons, if they are there, the less time you waste on a company that
is perhaps best to pass over.

You also carry out preliminary due diligence to get a
more accurate estimate of the price you plan to offer to make sure that you and
the seller are not too far apart.

The next article picks up where thisarticleleaves off
with the drafting of a letter of intent and formal due diligence.

————————————————————-

Reference: “How to Acquire the Right Business”

John Psarouthakis & Lorraine Uhlaner

Published by Xlibris, 2009

 

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