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 [email protected].
