Due diligence is a widely used term
that is not always used properly.
What does it mean?
“Due diligence is a transaction verification step when you’re considering investing in an organization, whether through a
merger, acquisition or an infusion of significant capital,” says James P. Martin, CMA,
CIA, CFD, CFFA, a senior manager with
Cendrowski Corporate Advisors LLC,
Bloomfield Hills, Mich.
Traditionally, the primary focus has been
on the numbers, says Martin. “Yet when
you also look closely at operations and
internal controls, you can obtain better
results from due diligence and achieve
greater long-term success. Analyzing the
people, processes and systems are steps
that are often overlooked, but doing so will
give you deeper insight into the company
and its prospects for the future.”
Smart Business asked Martin to provide
guidance for buyers preparing to enter into
due diligence.
Many mergers and acquisitions fail. How can
due diligence help?
The problem with focusing primarily on
the financials during due diligence, as
we’ve seen with capital markets in the last
few years, is an opportunity for the numbers to be skewed. The numbers primarily
reflect historical performance; due diligence should also focus on the people,
processes and systems that generated
those numbers. What are their procedures?
Do they have good internal controls? What
is the state of the IT systems?
An extremely important consideration is
company culture. During due diligence, the
acquirer should consider the target’s
human capital. What do the people
believe? How will they respond to the
merger?
More often than not, it’s the unsuccessful
meshing of two different cultures that
results in failure. And even if the cultures
are compatible, there is still a lot of distraction. Workers become disenchanted,
begin looking for new jobs, get lured away
by the competition, etc.
Considering the myriad issues on a holistic basis is what we refer to as ‘business
intelligence.’ This involves understanding
the value proposition of the business much
more deeply than a mere analysis of the
numbers, to understand how the organization operates, what can be expected for
future performance, and what events,
uncertainties, conditions or contingencies
could disrupt the achievement of business
objectives.
What areas receive special attention during
due diligence?
During due diligence, you want to ensure
that the numbers are fairly represented,
that sales are repeatable and that growth
will continue to be achievable. There is a
difference between looking at transactions, versus analyzing processes and procedures. A number is just a number. How
much did the company have to do to
achieve that number?
Some companies are good at achieving
results while always operating in a crisis
mode. In other companies, everything is
planned, and processes and procedures
are in place. It’s crucial for the buyer to
know how the company actually works,
what it is actually acquiring.
Much of what will receive closer examination during due diligence depends on the
buyer’s strategy. Why does the buyer want
to acquire the company? Is it trying to
obtain clients? Add human capital? Obtain
a patent? Penetrate a certain market?
When you acquire a business, you are
acquiring everything that goes with it.
How has Sarbanes-Oxley affected due diligence?
If the acquiring entity is a public company and the target is a private company, the
private company must be SOX compliant
from the minute the merger takes place.
Due diligence can quantify how compliant
the company is. It will require a significant
investment to bring a company that does
not have written policies and procedures in
place into compliance.
If two public companies were to merge,
during the process of combining operations department by department, they
would have to determine what the new
official procedures were going to be, then
document everything. Again, an expensive
proposition.
It is important to remember that even
though Sarbanes-Oxley was written as a
regulation covering large public companies, it has increasingly been applied to private companies, and even not-for-profit
entities as a best-practice standard. Many
of the governance and oversight requirements of SOX are applicable and valuable
when applied in a private company setting.
Also, since many features of Sarbanes-Oxley are derived from the Committee of
Sponsoring Organizations of the Treadway
Commission’s internal control framework,
they are certainly applicable to most organizations.
On another note, in the private equity
world, for example, the buyer would have
to consider its exit strategy. If an IPO is
down the road, the buyer would have to
build in the additional costs required to
develop and document SOX compliant
processes and procedures.
JAMES P. MARTIN, CMA, CIA, CFD, CFFA, is a senior manager with Cendrowski Corporate Advisors LLC in Bloomfield Hills,
Mich. Reach him at (248) 540-5760 or [email protected].