This article deals with the possible pitfalls and issues that may arise from time to time during the due diligence process in business acquisitions.
Due diligence is a process whereby one party conducts checks on the other party. In the context of M&A this process takes place immediately after heads of terms are signed and a deal is agreed.
The main checks are done on the seller and the company or business acquired in order to satisfy the buyer, their advisors and lenders (if appropriate) that the business is as described.
The three main sorts of due diligence are commercial, legal and financial although there may be many other areas that require checking before a deal can be concluded and these areas normally arise from initial checks in the main three areas which are commercial, legal and financial.
Commercial due diligence
This is a set of checks around the commerciality and the commercial validity of the business going forward. The buyer usually needs to satisfy themselves that the business performance is not likely to decrease due to market conditions (example: political or legislation change) or due to any internal situation (example: employment termination).
Legal due diligence
This is a set of checks that is usually done by the lawyer representing the buyer.
This set of checks is meant to satisfy the lawyer acting for the buyer that the business is not experiencing any litigation or legal challenges. The lawyer usually reviews the contracts with customers suppliers and employees to uncover any potential or immediate risks to the smooth operation of the business. Issues that arise from a legal view point can be mitigated by putting additional paperwork in place to minimise the risk involved in the findings.
Financial due diligence
This is a set of checks usually done by the accountant representing the buyer.
This set of checks is meant to satisfy the accountant acting for the buyer that the business numbers provided by the buyer are accurate and true. In particular the accountant will look at profitability as a snap shot and at a trend of profitability if it is upwards or downwards.
The accountant will typically also check whether the balance sheet items are true and the value adds up.
Problems that may arise from due diligence:
Should a situation be uncovered through due diligence it is mainly resolved through one of three ways:
Reduce the price
Defer payment over a longer period of time or alter the conditions of the deal without altering the actual price
Mitigate the risk and live with it
Issue: A few fundamental expertise exist within one person
In some cases a few fundamental expertise that are essential for the smooth running of the business exist within one key member of staff and that can cause a risk issue for the buyer as potentially, the investment they are making in the business is all dependant on an individual being well from a health view point and being willing to support the business.
Solution: Contract, insurance and training
In such cases the buyer must evaluate the risk associated with the position. They should examine the contract that the individual has in place with the business acquired and to satisfy themselves that this is solid enough to mitigate some of the legal risk. Insurance companies also offer Key man insurance which can be taken against lose of income arising from an individual becoming unwell.
In terms of development as oppose to continuity, the buyer must look at replacement opportunities and to assess who in the team may be able to acquire at least some of the skills. It is always a good idea to have overlapping skills within the team. After all, the buyer should mitigate risk associated with the transaction and this is a key area to work on.
Issue: An ageing client base
Through due diligence the buyer discovers that a large proportion of the clients are nearing a retirement age.
Solution: Assess the validity of the product/service to other markets and marketing.
If the buyer discovers that a large proportion of the clients are aging, in other words that the billing cycles in the business are limited there is very little they can do about the actual client base. Most buyers acquire businesses in order to add value and increase the value of the business over a period of time. One of the areas of development of businesses (especially well-established businesses) is marketing. If this area is a weakness then improving on it is likely to generate more leads which will result in more new customers. This needs to come hand in hand with assessing who the target audience could or should be and how such a market can be tackled with swift success.
Issue: A member of the family is managing the accounts or any other fundamental functionality of the business.
In many businesses the owner employs members of the family in key positions in the business due to trust that is required to perform that specific role. In many cases this role is related to the financial functionality
Solution: Replace or be very prepared to replace that person.
The person sitting in that key position is loyal to the owner of the business who is now exiting. As part of the acquisition a buyer can request that some employees resign without compensation and a buyer needs to know who these people are and what key positions they hold so they can line up someone else to pick up their responsibilities. A very typical example will be the financial functionality, bookkeeping etc. Especially in deals where not all the consideration is paid on day one there may be disagreements about the amounts due, timing and whether they are due at all. If you find yourself in such a position you must ensure that there isn’t anyone in your team who is playing for the other side. If you don’t replace them on day one at least recruit someone to shadow them so that they are prepared to take over at any moment should they be required to do so.
Issue: There are no contracts between the business and its staff/clients/suppliers.
In many companies you will find through the due diligence exercise that a lot of the business is done through trust and the contracts in place are either well out of date or they simply do not exist.
Solution: Ask the seller to put contracts in place or pay for the business over a longer period of time.
If there are no contracts in place there is no formal obligation on the other party (be it suppliers or customers) to perform in any way. This is a large increase of risk to almost any buyer. Dependant on the terms, the commitment taken on by the buyer and the amount of “new cash” introduced to the deal, the buyer may request that the seller approaches the suppliers, customers and staff and negotiate acceptable contracts with them prior to completion. Should the seller not agree to do that then clearly the risk will be there post acquisition. As the risk is mainly financial the buyer can mitigate some of it by ensuring that they collect their first instalment before making further instalments of consideration. This way while the risk is still in force the financial risk is mitigated and therefore reduced significantly. A buyer can do that through introducing a deferred consideration mechanism if not already in situ or extending an existing one.
Issue: The Company is in the middle of a litigation.
It may be that the company you are looking to buy is in live litigation with a supplier, customer or a member of staff.
Solution: Take legal advice of the worst case scenario and claw that amount back until the claim is settled, won or lost.
Any good litigation lawyer will be able to provide you with an opinion about the likely cost of a piece of litigation. The first answer is usually “unlimited” but there has to be a reasonable amount under which you are not willing to risk and beyond which it will be unreasonable to hold back cash as it will be disproportionate to the deal size. Example: a buyer identified during due diligence that there is an ongoing litigation with an ex-employee. The legal advice says that the maximum lose in the case is £5,000. The buyer can either law this amount back or get an undertaking from the seller personally that they would pay the cost of that litigation personally.
Issue: The lease on the building is not allowing for sub let.
In some cases the seller is operating the business from a premises which is either not properly utilised or the buyer wants to prepare a safety net should the business either shrink or wish to move away from its location.
Solution: Agree on a provision for sublease with the landlord or sign up for a shorter lease.
If the premises can be sublet that may give the buyer some comfort that should they wish to either receive an income from the surplus space they have in the building or move the business altogether.
Signing a shorter lease with the landlord (who is often the seller too) could give the buyer a shorter commitment which means lower risk.
Issue: The profitability of the business is not as high as the seller described it to be.
Business owners are optimists by nature and therefore in many cases overstate the profitability of the business. This is a dangerous move as often the valuation of the business is based, among other things, on profitability and a change in the profitability could mean a change in value although the sellers are usually caught completely off guard when it comes to it and usually this is a time when the very delicate rapport is being damaged.
Solution: Agree a formula at the start rather than a £ value.
If the buyer agrees a formula of valuation which is acceptable to the seller and the ingredients change, it is much easier to then sit together and work out the impact of the decrease in profitability on the actual price. If this is done at a fairly late stage of the deal then perhaps a “sweetener” should be used to show the seller an opportunity of receiving their original price subject to the performance of the business.
Issue: The stock is overstated on the accounts.
Often the business’s stock monitoring system will not be robust enough to support the activity and stock which is registered as existing on the system has actually already either gone into production or been sold.
Solution: Reduce the purchase price by the difference between the balance sheet stock and the existing stock.
If the asset value in reality is different than the value of the stock on a reliable independent stocktake then the buyer has a very good reason to discuss a discount on the overall consideration on the basis that the price is reduced by the difference between the balance sheet value of the stock and the actual valuation.
Issue: There is a large proportion of aged inventory on the balance sheet.
If the buyer identified that a large proportion of the inventory (over 60%) is aging and has not been used or sold over a long period of time (the duration and definition of ‘aging’ is dependent on the stock item and industry) this could mean that the effective balance sheet valuation is virtually reduced all be it that the actual balance sheet value is as it was stated before the due diligence.
Solution: Reduce the price of the business by the value of the ageing stock
A possible way forward is to reduce the price for the business by the value of the aging stock (once agreed by both parties), store the inventory free of charge for the seller and pay the seller for the items as they get into production or as they are being sold to the customer.