DUE DILIGENCE…….do you have a checklist? – Part I

 

I want to talk about the minefield I call ‘Due Diligence’.  I also want each of you to understand that your particular industries may be very different and thus require different kinds and levels of due diligence.  Therefore, you need to consult with your outside accounting firms and/or attorney(s)  for further discussion.

I am fortunate to have been involved in a number of acquisitions over the years, some big and some not so big.  It’s a great area of accounting and financial work which allows you to understand how businesses operate from the ground level.  However, this is an area that requires collaboration between people who are knowledgeable in such matters, such as your company attorney and outside accounting firm.

If you happen to be working for a publicly held company, most of those companies have well developed processes and procedures to guide them through the process.  But what are some of the things  (and certainly not all) you should be worry about.  Many small to medium enterprises (SME’s) achieve growth through acquiring other businesses………..sometimes in the same industry and sometimes not.  If you are a controller involved in or leading the acquisition team, be careful.  If the acquisition goes great and prospers, those who brought it to the table will generally get the credit, not you.  That’s fine.   If it fails during the process or turns out to be a dud after acquisition, you will likely be tainted by it or directly blamed.  If you have ever participated in the acquisition process, you should have built a checklist the first time and then refined and modified it as acquisitions were made.  But if you have no experience, you need to study how this process works and begin to build your checklist.  .  There are some great examples out there on the Internet, and on websites like AICPA.org if you are a member. I also recommend you visit the website of John Wiley & Co for books and manuals that might be of assistance.  Pitfalls abound in the acquisition business.  Trust me.

Critical to the process of buying a company is understanding that there can be limiting factors to its’ success.  First, understand why the company is for sale.  Reasons may include:

  • Owner wants to cash out and retire
  • Owner lacks capital to remain in business
  • Owner is afraid of continued credit risk
  • Owner does not feel capable of managing his company’s continued growth (result of rapid growth)
  • Owner is seeing a decline in his business
  • Owner is struggling with compliance issues (this can be an expensive area depending on your industry)

There are numerous reasons but I think the above covers a lot of them.  Whatever the reason, you need to apply the same due diligence learning why it is  for sale that you would if you were buying a previously owned home for your family.  Wouldn’t you ask the homeowner  ‘why are you moving?’, ‘how are the schools in this district?’, ‘what about the crime rate?’, etc.  You need an honest answer about why the business is for sale just as much as why that home is for sale.

Another area requiring skepticism, from my own past experience, is the appraisal that you are presented with.  Many businessmen, realizing the time has come to sell, will pay for an appraisal.  However,  the true value of a business is what someone is willing to pay in an arm’s length transaction.  I have seen a number of big appraisal books, plenty of drawings and photos, etc.  They can be works of art, and they are not cheap.  Do not accept an appraisal as the gospel.  Unfortunately there are not a lot of comparatives out there.  In the home buying business yes, not in the business buying business.  That’s a serious challenge.

Next week we will talk more about the acquisition process.  By the way, that includes a discussion of ‘falling in love’!

In the meantime if you have any questions, submit them below.

 

 

 

 

 

 

 

 

THE HP HORROR STORY – A LESSON ABOUT DUE DILIGENCE

According to today’s Wall Street Journal , in October 2011, HP (Hewlett Packard) purchased a U.K. company, Autonomy for $11 billion.  It doesn’t matter how big you are, that’s a lot of money.  Fast forward to 2012 (a year or so after the purchase according to WSJ) and HP took a write-down of $8.8 billion.  In my opinion, this is a staggering failure of due diligence.  The allegations  are that prior to the purchase, Autonomy had falsified its financial statements.  It is claimed that revenue was recognized for which there was no basis.  Purportedly, they claimed transactions for which there was no customer and other assorted falsifications.  I want to point that as stated in the WSJ, Autonomy has denied these allegations.

As Controllers, we are all subject to being involved in acquistions.  That can include new companies, buying out someone’s division, etc.  Even large capital investments like new software systems or a certain piece of equipment should be subjected to thorough due diligence/analysis prior to the purchase.

I know that many of us (including me) have a tendency to ‘fall in love’ with these acquistions.  We’re excited to see our companies grow and we recognize that new blood in our company may help revitalize it (and us).   The problem is that we are almost physiologically driven to ignore the bad news about an acquisition.

If you were a shareholder or any stakeholder, wouldn’t you want to know how this happened.  I think we already know that audited Financial Statements are no guarantee that they are not fraudulent.  One would hope that the materially distorted numbers were discovered, but as we have seen time and again, that simply is not the case.

Here are some of the questions I would raise if I was involved in the investigation:

1.  Did anyone look at their comparative financial statements for the last three to five years to see if their sales growth and profit made sense?

2.  Did anyone look at their sales reports to see how they tied out to their financials?

3.  How was the valuation of the company reached?  Obviously it was not worth anything related to the purchase price.  How could you take an $8.8 billion write down on a company you paid $11 billion for, and just a year ago?  That’s an 80% write down.

Controllers……………….you cannot let something like this happen to you.  In SME’s, we tend to be very proud of how quickly we can push through acquisitions versus our larger corporate colleagues.  But there is a downside to this.

So here is my advice based on past experience.

1)  I always liked to look at tax returns.  Very often they can raise questions you probably should have asked.

2) Assuming you are buying a business or division in your same industry, you should have some ‘instincts’ about what a reasonable set of financials should reflect.  Do the labor costs seem in line?  How much are they paying the officers?  Too little or too much?  If it’s not in your industry, resort to outside help…..someone who was familiar with the industry you are investing in.  If no one is available, there should be statistics/data out there that might assist you in your analysis.

3) With almost every acquisition I have been involved in, Year 1 after the purchase, expenses go up (sometimes dramatically) and sales go down.  Customers who may have felt some obligation to the ‘old’ company feel none towards the ‘new’ company.  Expenses go up because ‘old company’ decided to sell  two years ago and stopped investing and upgrading systems and assets.  Don’t forecast increased sales when you are putting together that ‘pro forma’ for the new company.  And don’t cut expenses because you think there will be economies of scale.  This advice generally holds true for most SME’s.  This is where that ‘love affair’ with your acquisition really kicks in.  Beware!

Finally – ‘TRUST BUT VERIFY’.  Your career may depend on it.

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