Acquisition Due Diligence (#80)
/In this podcast episode, we discuss some of the key items to look for when conducting due diligence on a target company. Key points made are noted below.
Why We Need Due Diligence
Due diligence is the investigation of a target company by the buying company. This is a seriously detailed review of the target’s operations and financial results. A novice buyer won’t spend much time on it; but experienced buyers will have seen so many problems over the years that could have been avoided with proper due diligence that they insist on it.
So for an experienced buyer, the objective is to use due diligence to uncover every possible reason why the acquisition will not work. You want to know all about these issues in advance, so you can think about whether you can overcome them or not. If not, then walk away.
I’m not going to discuss every possible due diligence question – for that, go to accountingtools.com, click on the Resources button, and you’ll see a due diligence checklist that’s about six pages long. Feel free to copy it.
What I AM going to do is spotlight some of the key areas where I’ve seen problems in the past – which, by the way, is somewhere around 100 reviews.
Review the Financial Statements
We’ll start with the financial statements, but keep in mind that this is only a piece of the review. If you just look at the numbers, you’ll miss a great deal. So, first – the question is, what is not there? Quite a few companies have an annoying habit of only charging certain expenses at the end of the year, like depreciation and bonuses – so if they give you financials for almost the entire year, then see if these items are included. If you need to guess at what these extra expenses might be for partial year results, and then go back to their last full-year results and see what expenses they recorded then.
Next, look at the trend of fixed assets over the past five years. If it’s trending up fast, then you can expect to see that they’re capitalizing expenses. It might even be legitimate, like for software development expenses, but you need to factor it into the company’s real year-to-year cash flow. About 2/3 of the software companies I’ve reviewed were capitalizing so much development cost that they looked really profitable, but they were actually close to bankruptcy.
Next, look at the margins. I look at net margins, not gross margins, because people can fudge the gross margin by shifting expenses out of it. There needs to be a consistent net margin over several years. Otherwise, if margins are small and getting smaller, you have to wonder how the acquisition will pay off for the buyer.
Review the Management Team
Next up, and frequently more important, is a review of the management team. You have to travel to the target company’s location to do this, so you can see these people in their own setting, and see how their own employees react to them. There are lots of clues to pick up about people, and it requires a lot of face time.
So, what am I looking for? In all cases, we leave the management team in place, so we have to be able to work with them, probably for years. So, the most critical issue is to avoid the command-and-control types. This is someone who is at the center of everything, and who has to make every decision. These people never ever fit into a larger organization. When I see a company president like that, I cut short the due diligence, and head for home.
So, how can you spot these people? One surefire indicator is when they have to be in the room with you during the entire visit; they don’t trust a subordinate to answer questions. Another method is to ask subordinates what kinds of decisions they have to defer to the boss.
In one case, I spotted it by reviewing their policies and procedures manual. For every procedure, absolutely everything required the approval of the president.
Now, due diligence discussions can be pretty broad ranging, so I like to drop hints about what it would be like for them to be part of a larger company, just to get a rise out of them. For example, if I mention that the entire company operates on a single medical plan, or a single pension plan, the point is to see if they’ll complain that their plans are better, and that their employees will suffer under our plans. I don’t really care about the differences between the plans – I’m trying to learn about their ability to fit in.
Review the Products
After the financials and the people, I look at the products.
If they’re a service organization, then I’ll deconstruct profits right down to the billable percentage and billing rate of each employee or department, so I can figure out exactly where the profits are.
If it’s a product company, then I absolutely want to know if they’re a one-hit wonder that still squeezing cash from the original product, or if they’re actually good at cranking out new products. You can see part of this by reviewing a time line of when they’ve released new products, but what I really like to see is revenue by product for the last three years. What I frequently see is that the old mainstay product still hogs the revenue, while the company is piddling away its cash on unprofitable new products.
Review Bottlenecks
And then there’s the bottleneck analysis. A lot of the time, this means that most of the sales are coming from just a few maxed-out salespeople. Other times, it’s a machinery constraint, but – usually, it’s people that are keeping the target from growing.
The Sequence of Activities
What is my due diligence sequence? The financial piece is first, because it’s my initial gate. If a target is blatantly unprofitable, then the due diligence is over, and I won’t waste any more time. If things look good on paper, then I schedule a trip, with the intent of spending as much time meeting as many people as possible. If things still look good – and keep in mind that we’re now down to just a fraction of the initial group – then I go back for a second trip, with more people, and we really dig in. In other words, this is a multi-layered progression. We don’t want to put too much effort into it, so we build in a number of decision points to see if we should walk away.
Completing the Analysis
So, what is the result of a due diligence review? Well, in my case, I go in assuming that I’ll find something critical that will make the acquisition fail. And that’s totally acceptable. I’d much rather find that out during a fairly inexpensive due diligence review, than afterwards, when we’ve already spent a few million dollars on the deal.
The final due diligence step is to document everything in a report. This is intended to be a summary of the target company, and its financial and operational results, but I spend the most time specifying the main problems, and whether I think we can fix them.
And last of all, I put in a recommendation. I leave no room for interpretation by the reader, because if it’s a bad situation, I want them to know.
Oh, and finally – the oddest thing I’ve ever seen in a due diligence is a software company that invested in – graveyards. The president’s spouse wanted to invest in graveyards, so how could the president possibly say no to that?