Deal or no deal Featured

7:00pm EDT November 25, 2008

Whether you’re buying a car, a house or a company, you want to know you’re buying a good product at a fair price. That’s why proper due diligence plays a crucial role in successful mergers and acquisitions.

“I don’t see buying a company as a whole lot different than purchasing a car, a house or any other asset,” says Mark J. Kosminskas, partner in the Corporate Practice Group at Levenfeld Pearlstein, LLC. “You need experts in different areas to ‘look under the hood’ to avoid unpleasant surprises, determine the extent of repairs and identify deal killers as early as possible in the process.”

Smart Business spoke with Kosminskas about what should be included in due diligence, who should complete it and how to accomplish it most effectively.

Why is due diligence a critical process for buyers and sellers?

With sellers, it’s ideal to perform a due diligence review at least 90 days before they go to market so that they can look at their company through the buyers’ eyes. This helps them discover areas of concern and allows them to develop a response to any problems before negotiations begin. Proper due diligence is like running a restaurant — presentation matters. If you’re super organized and aware of any deficiencies, it shows buyers that you’re on top of your game and you mean business.

On the buyer’s side, proper due diligence ensures that the buyer hasn’t overpaid for a company. It also protects the buyer from undisclosed liabilities that could lead to unanticipated expenses in the future.

From both perspectives, identifying material problems as early as possible is important. Mergers and acquisitions are very costly and the earlier in the process any deal breakers can be identified, the better. It’s kind of like dating — it is better to find out on the first date rather than the 12th that the relationship is destined to go nowhere.

What are the key areas for performing due diligence?

Financial: The buyer’s CPA firm usually completes the review of the company’s financials and accounting methodologies. One of the benchmarks for a well-run finance department is that the month-end books should be closed within 30 days. If that can be achieved, it indicates that the company has sufficient staff and efficient procedures, which result in timely access to key indicators for management.

Legal: Legal due diligence involves everything from checking the corporate documentation and records to reviewing loan agreements and contracts, outstanding litigation, and legal compliance.

Operational: This area covers ‘time and motion’ analysis and answers these questions: What does the company do? How does it provide goods or services? How does it sell them? A consultant or an area expert, such as a plant engineer, can review these processes.

Strategic: Good company buyers perform a SWOT (strengths, weaknesses, opportunities, threats) analysis and will not only analyze what they see today but also what they expect to see tomorrow. Potential buyers need to look for synergy and project growth opportunities three, 10 or even 20 years down the road.

What are the areas that pose the most risk or are sometimes overlooked?

It’s important to remember that material problems vary deal to deal and company to company. Where you spend time and money in due diligence is very industry dependent. If you were looking at a 30-year-old paint business with 14 plants across the country, you would want to bring in environmental experts to examine environmental compliance. Conversely, with a software company, you would turn to intellectual property experts to focus on checking your IP rights and protections.

That being said, there are two areas that always stay on my due diligence list:

Capital expenditures: It’s tempting for owners to curtail capital expenditures when they’re planning on selling. If I’m a buyer, I need to not only look at the historical numbers but also project how much cash the company will generate and how much I will need to spend on future capital expenditures. If the owners haven’t kept up on these investments, that will affect what the buyer is willing to pay.

Cultural integration: Even if a company looks great financially, legally, operationally and strategically, it’s really important for managers to do a temperature check on whether it’s a good cultural fit with any existing platform company. If you try to blend a culture that is very team-oriented and mutually supportive with a bunch of individualist mavericks, it’s very likely that the merger won’t go well.

MARK J. KOSMINSKAS is a partner in the Corporate Practice Group at Levenfeld Pearlstein, LLC. Reach him at (312) 476-7886 or mkosminskas@lplegal.com.