Half of all business mergers and acquisitions fail because things just don’t turn out as executives planned.
Acquisition value is often based upon a business’s past performance, and many executives rely on in-house personnel to conduct historical financial analysis only to be surprised later because the past isn’t always indicative of future earnings. An acquired company may not sustain growth if market conditions change, key employees leave or the company’s expense levels are too high compared to industry norms. An external financial due diligence review will uncover many of these hidden risks so executives can appropriately determine the acquired company’s true value.
“In M&A transactions, often what is not discovered through due diligence or unknown items are what really come back to bite you after the deal is done,” says Pat Ross, audit partner with Haskell & White LLP. “While earn outs or other contingency payments are designed to mitigate this risk, they can’t remedy the distraction of executives who have to deal with post-acquisition problems. Why not have a clear picture upfront, so you know exactly what you are buying?”
Smart Business spoke with Ross about the value of professional due diligence and the areas that produce the most frequent post-M&A surprises.
How can financial due diligence project future earnings quality?
It’s vital to understand how the target company earns its profit to know if that will continue. Sometimes a highly profitable division may have been sold or a competitor may have gained the upper hand in the marketplace with new technology. If margins or revenues will be impacted in the future, you won’t know that by looking at past or current financial statements, which are typically backward looking. Executives also need to know if the target has a consistent, stable customer base or if there have been one-time large orders that will not repeat, or non-operational gains. It’s important for the due diligence team to assess the marketplace and the target’s position to know if the acquisition price is right.
What are potential SG&A surprises?
Perhaps the owner of the target company didn’t take a salary for a year while he readied the company for a potential sale, or maybe the current staff is paid above or below the going market rate. These are situations that can cause big problems when new owners need to hire additional staff or are forced to offer substantial salary increases to mitigate turnover. You also want to know if there have been any extraordinary expenses, like lawsuit settlements, and whether those are likely to recur and how the target company’s expenses compare against industry benchmarks. How the company performs against its peers in all categories is an important predictor of future success.
How can human capital influence M&A success?
It’s important to understand if the target company’s financial performance is driven by a few key personnel. If so, they will need to be retained, and the due diligence team can assess current management in order to understand the relationship between it and the company’s future profit prospects. For example, items assessed can include: When and how are commissions paid to the sales staff members? Is the bonus schedule competitive? Might they woo away key customers if they go to work for a competitor? These are some of the questions that should be asked and understood before making an offer.
What are some hidden risks?
Back taxes, IRS liens and EEO lawsuits can be disruptive or even catastrophic if CEOs have to deal with them after the acquisition; a solid external due diligence review can uncover the potential of any of these events occurring. Also, be certain that you’re getting clear title to the assets you’ll be buying, the company has effective accounting controls and processes in place and the business has been adequately insured. The likelihood of a lawsuit or claim surfacing after the acquisition increases if the business hasn’t practiced sound management or risk management fundamentals in the past.
What constitutes an external financial due diligence review?
The due diligence professional will sit down with management in the preliminary stages to gain an understanding of the proposed deal, including the upside and potential downside, then he or she can calibrate the due diligence procedures to assess the potential risks in a variety of financial and nonfinancial areas. A customized plan will be prepared to perform investigative procedures around those risks and determine if there are real or perceived risks and any potential mitigating factors. The key here is to understand if the deal is likely to look just as attractive in a few years as it does today.
PAT ROSS is an audit partner for Haskell & White LLP. Reach him at (949) 450-6362 or PRoss@hwcpa.com.