How to make due diligence a key component of your M&A transactions Featured

7:00pm EDT November 25, 2010

The merger and acquisition (M&A) market is heating up. After a period of restraint during the recent economic downturn, transaction activity is again on the rise.

According to Tom Powers, CPA, director of assurance and business advisory services at GBQ Partners LLC, total transaction volume through the third quarter has surpassed total transaction volume in 2009.

If your company is thinking about undertaking a merger or acquisition, now’s a good time to research the current trends in due diligence and make sure you’re prepared for a smooth transition process.

“You need to make sure you’re paying the right value for what you’re buying,” says Powers. “Are you getting what you think you’re getting? Are you buying what you think you’re buying? Understand the risks and opportunities and make sure they’re consistent with your expectations.”

Smart Business spoke with Powers about due diligence and how to make it a key component of your M&A transactions.

What key things do you need to understand about due diligence?

There are different areas that need to be taken into consideration, such as financial facts, operations and human resources. Sometimes some of the other non financial areas could be more critical, because they might truly be the value of the company. You have to look at customers and employees and assess whether they will remain after the purchase.

The leverage has shifted to a buyer’s market. Before, in a seller’s market, the seller had more leverage and required a fast process or had multiple bidders. Now you might have one bidder and four sellers. People take more time, are more cautious and try to obtain more certainty before they finalize a deal — it doesn’t have to be a rush.

What types of due diligence need to be performed during an M&A transaction?

It should be more of a risk-based approach. Understand the mechanics of the arrangements you’re getting into. It’s always better to do a risk-based approach versus wall-to-wall due diligence. Work through a checklist of where your uncertainties might be. Consider the historical performance of the company, the projected performance, the balance sheet, the strengths and weaknesses and tax. If it’s a stock deal, it might come with potential tax liabilities and you need to understand the tax risks. You also need to look at the commercial side, including competition, marketing, human resources and operations.

What are some current due diligence trends?

With the shift in negotiating power to the buyer, coupled with the continued uncertainty, buyers are increasingly seeking to negotiate deal protection by contractually agreeing to shift the risks associated with uncertainty onto the seller. Buyers are insisting on having protection to claw back portions of the purchase price. Earn-outs, escrows, holdbacks and expanded indemnification are increasingly widespread.

Cost efficiency is also important. Buyers are trying to reduce the cost of due diligence by executing a focused, risk-based due diligence process. If claw backs or other buyer protections can be negotiated, the need for extensive due diligence can be avoided. Buyers can then focus on unmitigated areas of risk.

Companies have slashed investments over the past two years. Acquirers should examine whether a target was able to maintain sufficient investment in the key parts of its business to retain its critical advantage.

Also, companies might look healthier than they actually are. Some have cut costs in areas like research and development or sales and marketing. You need to figure out what initiatives were put in place for the company to return to, or retain, profitable levels during the recession.

More and more sellers are trading in the three-ring binders and physical data rooms for virtual data rooms, where documents can be searched and retrieved online. There are a number of vendors who provide this service at a reasonable cost, and efficiencies are gained on both the buyer and seller side.

What should sellers consider?

Be prepared. Make sure information is clean and easy for the buyer to undergo due diligence. Organization and readiness of documents will lead to a quicker due diligence period and instill confidence in the buyer.

Sell the business before you have to. The worst time to sell a business is when you absolutely have to sell. Buyers will know you are desperate. Take a buyer’s perspective — consider whom the key buyers might be and anticipate their motivators. Articulating that strategic fit will drive better multiples. Review your key client contracts and get them extended for longer periods. A buyer is evaluating your long-term sustainable revenue streams when arriving at a valuation.

Prepare for due diligence before a deal arises. Will you need or desire to have audited financial statements, which could enhance value or lessen the due diligence barrage? Also, hire a consultant two years before you want to sell to help undergo reverse due diligence and uncover and remedy potential issues.

Tom Powers, CPA, is the director of assurance and business advisory services at GBQ Partners LLC. Reach him at (614) 947-5215 or tpowers@gbq.com.