Tough Times Require Tougher Due Diligence

Current economic difficulties accentuate the importance of conducting effective and thorough due diligence in any merger or acquisition transaction. Items requiring investigation include:

• Measuring the last twelve months (LTM) performance in comparison to historical results

• Increased aging of accounts payables

• Declining gross margins

• Declining order backlogs

• Recent losses of customers

• Increased inventory levels

• Increased accounts receivables levels

• Eliminations, deferrals or reductions in employee bonuses

• Creditworthiness of customer base.

Crucial concerns may get overlooked in a cursory examination of a company’s financial statements. Further examination may reveal that too many of a company’s customers are experiencing acute financial difficulties. Many accounts receivables may need to be written off as uncollectible. Further examination may also reveal that too many current agreements and business practices are based upon decisions made in better economic times, or poor current decisions may have long-term consequences.

A company cannot eliminate all the risks and uncertainties associated with each potential merger or acquisition. In defining the scope of its due diligence investigation, however, a company determines the level of risk it is willing to accept in pursuing a transaction.

Acquisition Considerations

A merger or acquisition must generally serve a strategic objective. While the present economic climate may have driven down transaction prices, it has also illustrated the need for additional investigation.

A chain of retail clothing stores, for example, may consider acquiring another retail clothing store chain, thereby attaining greater economies of scale. An examination of inventory by an industry expert, though, may reveal that the retailer considered for acquisition is assigning considerable value to merchandise that it has little, if any, chance of selling at regular retail prices.

A hydraulic parts distributor may purchase a hydraulic equipment repair business, thereby attaining synergy and making it more of a one-stop source for its industrial customers. Through investigation, though, the distributor discovers that the repair business faces the possibility of not having several large contracts renewed by existing customers.

In each instance, the acquiring company based its interest on a strategic objective and then exercised the necessary due diligence.

That diligence extends to assigning value and determining an appropriate purchase price for the targeted company. The acquiring company may also decide that it is only interested in purchasing particular assets, such as customer lists, real estate, inventory, or surface or mineral rights.

Being aware of a strategic purpose, valuation methods, and the option to only purchase selected assets prepares a company for addressing crucial aspects of the due diligence process.

It Begins with Planning

Initiating due diligence requires an overall plan, a plan that considers how a company’s merger or acquisition objective will be integrated with its business development program.

Understanding how a merger or acquisition strategy can be integrated with business development goals helps a company visualize the ideal transaction. That visualization can help the company determine what benchmarks or triggering events would prompt it to terminate a transaction.

Such benchmarks or events are especially important during prolonged economic downturns. The targeted company may be deferring payments for a number of goods and services it purchased. It may be engaged in disputes with vendors. Those events may indicate that the company is having considerable difficulty meeting accounts payable obligations. Being aware of factors that would make a merger or acquisition unacceptable helps the company avoid making a transaction it later regrets.

Having agreement and input on risk areas and procedures from those responsible for operating the new entity once the transaction is completed is vital. That ensures accountability and ownership for crucial operational processes, compliance requirements, and other potential vulnerabilities following the transaction’s completion.

Accounting Issues

When a company identifies a suitable transaction opportunity, it must decide what it will use as basis for determining valuation for the entity. If the entity is a publicly-traded corporation, a valuation may be based on its stock price. Determining valuation for a privately-held entity entails determining the worth of various assets, including inventory, equipment, intellectual property, and real estate, as well as the expected cash flows derived from the combined use of these assets.

The company must also evaluate how the entity monitors assets and liabilities. Assets and liabilities subject to a high degree of estimation—such as accounts receivables, valuation allowances, intangible assets, and loan losses—present particular risks and require scrutiny, especially if those estimates are based on assumptions made several years ago.

Contingent liabilities for leases and pension funding must be identified. Also, the company must be aware of payments from triggering events linked to a change in control, or any other specific issues associated with the entity and a pending transaction.

Reviewing external auditor work papers provides additional insight regarding the entity’s financial reporting practices. The work papers reveal details regarding the audit planning, procedures, and testing. How were accounts receivables confirmed? Were conditional or contingent sales included? What percentage of accounts receivables could reasonably be deemed collectible? Evaluating work papers provides answers to such questions.

Tax, Legal, Insurance Issues

Depending upon where a company sells its products, where its employees work, where it maintains facilities, or other criteria, it may have nexus for state or local taxes, without being aware of such obligations. That nexus would transfer to the acquiring company. Other events, such as a change in entity structure, may also present potential tax ramifications that need consideration.

In completing a transaction, a company may face new regulatory requirements related to the acquired entity’s operations, products, services, industry or location. Is that entity facing any lawsuits? Are there any letters of intent, commitments, or other undisclosed agreements the company would need to honor?

In evaluating the entity’s property, the company needs to determine if there are any rights restrictions or provisions in deeds or leases that could make an acquisition costly or unfeasible. Shareholder and regulatory consent may also be necessary to complete the transaction.

The company also needs to evaluate insurance consequences—changes in premium costs, as well as the ability to retain coverage—associated with acquiring that entity. Addressing such legal and insurance concerns reduces the risks of unpleasant scenarios unfolding as a transaction moves further toward completion.

Business Operations and IT Infrastructure

Reviewing business operations and IT infrastructure helps identify potential vulnerabilities, difficulties and expenses. Daily operational processes require evaluation to determine whether any identified vulnerabilities associated with those activities are mitigated.

Outsourced services, such as accounting, actuarial, and payroll functions need review as well. Attaining an understanding about each service provider provides insight into any perceived risks, as well as how the company deals with those vulnerabilities. External auditor work papers can be helpful in this regard.

How are the entity’s suppliers and customers concentrated? Do those concentrations lend themselves to greater efficiency? Do they complement the company’s concentrations? Do those concentrations unduly expose the company to risks facing those suppliers and customers?

The target entity’s sales force should be reviewed as well to determine its effectiveness and to uncover any overlaps with the acquiring company’s existing sales force. The company then needs to consider as well, how that sales force would be integrated within its business development efforts.

IT considerations present particular concern when examining a company’s operations and attractiveness for a merger or acquisition. Critical questions include:

1. Scalability. Are information systems (hardware and software applications) unique and/or can they be easily integrated into the purchaser’s platform?

2. Integration Risks. Would target’s information systems support operational growth?

The acquiring company must also evaluate current IT practices within the target company. What sort of existing controls are being used? How many individuals have access to critical information? How well is data integrity, data security, data reliability and other needs addressed?

Such IT considerations enable the company to make informed decisions regarding potential post-transaction costs or difficulties.

Human Resources

Individuals make businesses successful, and human resources issues must be addressed during due diligence. How do current payroll statistics compare to past results? Has a company deferred, eliminated or reduced bonus payments? Could those actions be a warning sign of impending departures or a potential loss in critical skills?

Workplace cultures between the company and the entity it is considering acquiring may vary immensely. Cultural gap indicators, such as differences in dress codes, work schedules, and benefits must be recognized and integrated. Specific individuals may possess vital talent, industry acumen, institutional knowledge, or valuable relationships with customers, vendors and suppliers.

The potential negative impact the company may experience if those individuals, customers, supplier or vendors leave once the transaction is completed may be immense. The company must consider that risk.

The entity to be acquired may have employees represented by a union or labor contract. Compensation and benefit plans may obligate the acquiring company to considerable expenses. Those expenses must be acknowledged. Being aware of such issues and involving crucial individuals from both businesses in the integration process helps the company avoid critical human resources concerns.

Current economic conditions present many acquisition and merger opportunities, as well as risks. By exercising proper due diligence, the company increases the likelihood that all stakeholders will benefit from a transaction.

Brian A. Reed, CPA, CVA is the director of Transaction Services at Weaver, ranked the largest independent certified public accounting firm in the Southwest with offices throughout Texas. He can be reached at 972.448.6936 or