Due diligence Featured

7:00pm EDT March 28, 2006
“Due diligence” is a term thrown around quite a bit among lawyers, accountants and consultants during a business acquisition. But what does it mean for the business professional involved in a commercial transaction? While many business owners may have a vague idea of its implications (that a lot of information needs to be gathered within a certain time frame to protect the company’s financial interests), what they may not know is that due diligence is a prime opportunity to go beyond the numbers and find out if the perceived value of the company is at risk once the deal is done.

“One of the biggest mistakes that inexperienced acquirers make is assembling massive quantities of historical information as opposed to focusing on the specific elements of the transaction that are critical to the creation of value,” says Chris Meshginpoosh, director of consulting services for Kreischer Miller.

Smart Business spoke with Meshginpoosh about due diligence.

 

What, exactly, is due diligence, and why is it important when purchasing a business?

 

Due diligence is a process meant to identify risks impacting an acquirer’s ability to achieve expectations. These can include risks from pending litigation, increased competition, negative trends in supplier relationships or the loss of key employees.

While many elements of due diligence are similar across all transactions, effective due diligence involves identifying valuable assets and then designing due diligence procedures that focus on them. This is crucial, because the motivations behind different transactions can vary widely. In one case, the primary motivation might be the opportunity to gain access to a new class of customers; in another, the motivation might simply be to acquire intellectual property. The risks associated with customer relationships are different than the risks associated with intellectual property.

 

How does the process of due diligence begin?

 

First, it is customary for both parties to agree to a letter of intent that details terms of the anticipated transaction — such as purchase price, proposed closing date and general obligations of the seller to assist with the acquirer’s due diligence efforts. Once the parties have reached agreement on the terms of the letter of intent, due diligence ordinarily commences very quickly and involves a team of managers, attorneys and accountants.

 

What can go wrong during due diligence?

 

A lot. By almost all accounts, the failure rate of mergers and acquisitions is as high as 80 percent. The primary obstacle is the lack of relevant information available to the acquirer. In the vast majority of transactions, the seller seeks to keep the proposed transaction confidential to mitigate concerns on the part of customers or employees. Yet an open dialogue might be critical to identify relevant risks.

For instance, if you seek access to a new class of customers, then the quality of the company’s relationships with its customers is probably a primary area of concern. However, the company might not allow you to contact its current customers for fear of customer losses.

Or, in the case of a service business, the quality of the company’s relationships with its employees might be of critical importance. But again, the target might not want you to talk to the general employee population for fear of increased employee turnover.

In either case, the buyer has a difficult decision: acquiesce and accept the resulting risk, or push the issue and alienate the management team that it might have to rely upon after completion of the transaction.

 

How can you increase the chances of success?

 

In addition to experienced attorneys and accountants, it is important to include a multi-disciplinary team of managers that will have to live with the results of the transaction. That means involving sales, operations and human resources in the planning process. Their job is to identify potential risks, challenge preliminary assumptions made by senior management, and design procedures meant to provide insight into these areas of risk.

Once those procedures are planned, don’t take no for an answer. Some of the best acquirers have a policy of walking away from a transaction at the first sign of a seller’s failure to cooperate.

 

Can you offer any other cautionary advice?

 

Once due diligence commences, professional skepticism is critical. The seller always puts the best spin on historical results and future opportunities. As an acquirer, it is essential to avoid getting caught up in the excitement of the transaction and to avoid rationalizing away warning signs.

Perhaps the most important success factor is experience. Accordingly, it is critical to ensure that you have a team of experienced people providing you feedback, advice and objective information. Having the advice of experts, combined with the buy-in of team members who have to live with post-merger results, will help you succeed where most fail.

 

CHRIS MESHGINPOOSH is the director of consulting services at Kreischer Miller, an accounting firm based in Horsham, Pa. Reach him at cmeshginpoosh@kmco.com or (215) 441-4600 x139.