The Letter of Intent has been signed by both buyer and seller and everything seems to be moving along just fine. It would seem that the deal is almost done. However, the due diligence process must now be completed. Due diligence is the process in which the buyer really decides to go forward with the deal, or, depending on what is discovered, to renegotiate the price – or even to withdraw from the deal. So, the deal may seem to be almost done, but it really isn’t – yet!
It is important that both sides to the transaction understand just what is going to take place in the due diligence process. The importance of the due diligence process cannot be underestimated. Stanley Foster Reed in his book, The Art of M&A, wrote, “The basic function of due diligence is to assess the benefits and liabilities of a proposed acquisition by inquiring into all relevant aspects of the past, present, and predictable future of the business to be purchased.”
Prior to the due diligence process, buyers should assemble their experts to assist in this phase. These might include appraisers, accountants, lawyers, environmental experts, marketing personnel, etc. Many buyers fail to add an operational person familiar with the type of business under consideration. The legal and accounting side may be fine, but a good fix on the operations themselves is very important as a part of the due diligence process. After all, this is what the buyer is really buying.
Since the due diligence phase does involve both buyer and seller, here is a brief checklist of some of the main items for both parties to consider.
Figure the percentage of sales by product line, review pricing policies, consider discount structure and product warranties; and if possible check against industry guidelines.
Review names, positions and responsibilities of the key management staff. Also, check the relationships, if appropriate, with labor, employee turnover, and incentive and bonus arrangements.
Get a list of the major customers and arrive at a sales breakdown by region, and country, if exporting. Compare the company’s market share to the competition, if possible.
Review the current financial statements and compare to the budget. Check the incoming sales, analyze the backlog and the prospects for future sales.
Accounts receivables should be checked for aging, who’s paying and who isn’t, bad debt and the reserves. Inventory should be checked for work-in-process, finished goods along with turnover, non-usable inventory and the policy for returns and/or write-offs.
This is a new but quite complicated process. Ground contamination, ground water, lead paint and asbestos issues are all reasons for deals not closing, or at best not closing in a timely manner.
This is where an operational expert can be invaluable. Does the facility work efficiently? How old and serviceable is the machinery and equipment? Is the technology still current? What is it really worth? Other areas, such as the manufacturing time by product, outsourcing in place, key suppliers – all of these should be checked.
Trademarks, Patents & Copyrights
Are these intangible assets transferable, and whose name are they in. If they are in an individual name – can they be transferred to the buyer? In today’s business world where intangible assets may be the backbone of the company, the deal is generally based on the satisfactory transfer of these assets.
Due diligence can determine whether the buyer goes through with the deal or begins a new round of negotiations. By completing the due diligence process, the buyer process insures, as far as possible, that the buyer is getting what he or she bargained for. The executed Letter of Intent is, in many ways, just the beginning.
Buying a Business – Some Key Consideration
- What’s for sale? What’s not for sale? Is real estate included? Is some of the machinery and/or equipment leased?
- Is there anything proprietary such as patents, copyrights or trademarks?
- Are there any barriers of entry? Is it capital, labor, intellectual property, personal relationships, location – or what?
- What is the company’s competitive advantage – special niche, great marketing, state-of-the-art manufacturing capability, well-known brands, etc.?
- Are there any assets not generating income and can they be sold?
- Are agreements in place with key employees and if not – why not?
- How can the business grow? Or, can it grow?
- Is the business dependent on the owner? Is there any depth to the management team?
- How is the financial reporting handled? Is it sufficient for the business? How does management utilize it?
Two businesses for sale could report the same numeric value for “earnings” and yet be far from equal. Three factors of earnings are listed below that tell more about the earnings than just the number.
1. Quality of earnings
Quality of earnings measures whether the earnings are padded with a lot of “add backs” or one-time events, such as a sale of real estate, resulting in an earnings figure which does not accurately reflect the true earning power of the company’s operations. It is not unusual for companies to have “some” non-recurring expenses every year, whether for a new roof on the plant, a hefty lawsuit, a write-down of inventory, etc. Beware of the business appraiser that restructures the earnings without “any” allowances for extraordinary items.
2. Sustainability of earnings after the acquisition
The key question a buyer often considers is whether he or she is acquiring a company at the apex of its business cycle or if the earnings will continue to grow at the previous rate.
3. Verification of information
The concern for the buyer is whether the information is accurate, timely, and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectable receivables? Is the seller above-board, or are there skeletons in the closet?
In order to sell one’s business using the services of a business broker, a listing agreement is almost always required.
For the owner of the business, signing the agreement legally authorizes the sale of the business. This simple act of signing represents the end of ownership. For some business owners, it means heading into uncharted territory after the business is sold. For many it also signifies the end of a dream. The business owner may have started the business from scratch and/or taken it to the next level. A little of the business owner may always be in that business. The business, in many cases, has been like a part of the family.
For buyers, the signed listing agreement is the beginning of a dream, an opportunity for independence and the start of business ownership. The buyer looks at the business as the next phase in his or her life. Pride of ownership builds.
So, that simple piece of paper – the listing agreement – is the bridge for both the seller and the buyer. The business broker looks at that piece of paper through the eyes of both the buyer and the seller, working to help both parties progress through the business transaction process into the new phase of their lives.Read More
Buyers, as part of their due diligence, usually employ accountants to check the numbers and attorneys to both look at legal issues and draft or review documents. Buyers may also bring in other professionals to look at the business’ operations. The prudent buyer is also looking behind the scenes to make sure there are not any “skeletons in the closet.” It makes sense for a seller to be just as prudent. Knowing what the prudent buyer may be checking can be a big help. A business intermediary professional is a good person to help a seller look at these issues. They are very familiar with what buyers are looking for when considering a company to purchase.
Here are some examples of things that a prudent buyer will be checking:
- Is the business taking all of the trade discounts available or is it late in paying its bills? This could indicate poor cash management policies.
- Checking the gross margins for the past several years might indicate a lack of control, price erosion or several other deficiencies.
- Has the business used all of its bank credit lines? Does the bank or any creditor have the company on any kind of credit watch?
- Does the company have monthly financial statements? Are the annual financials prepared on a timely basis?
- Is the owner constantly interrupted by telephone calls or demands that require immediate attention? This may indicate a business in crisis.
- Has the business experienced a lot of management turnover over the past few years?
- If there are any employees working in the business, do they take pride in what they do and in the business itself?
- What is the inventory turnover? Does the company have too many suppliers?
- Is the business in a stagnant or dying market, and can it shift gears rapidly to make changes or enter new markets?
- Is the business introducing new products or services?
- Is the business experiencing loss of market share, especially compared to the competition? Price increases may increase dollar sales, but the real measure is unit sales.
When business owners consider selling, it will pay big dividends for them to consider the areas listed above and make whatever changes are appropriate to deal with them. It makes good business sense to not only review them, but also to resolve as many of the issues outlined above as possible.Read More
Once a buyer has negotiated a deal and secured the necessary financing, he or she is ready for the due diligence phase of the sale. The serious buyer will have retained an accounting firm to verify inventory, accounts receivable and payables; and retained a law firm to deal with the legalities of the sale. What’s left for the buyer to do is to make sure that there are no “skeletons in the closet,” so he or she is not buying the proverbial “pig in a poke.”
The four main areas of concern are: business’ finances, management, buyer’s finances, and marketing. Buyers are usually at a disadvantage as they may not know the real reason the business is for sale. This is especially true for buyers purchasing a business in an industry they are not familiar with. The seller, because of his or her experience in a specific industry, has probably developed a “sixth sense” of when the business has peaked or is “heading south.” The buyer has to perform the due diligence necessary to smoke out the real reasons for sale.
Business’ Finances: The following areas should be investigated thoroughly. Does the firm have good cash management? Do they have solid banking relations? Are the financial statements current? Are they audited? Is the company profitable? How do the expenses compare to industry benchmarks?
Management: For a good quick read on management, the buyer should observe if management is constantly interrupted by emergency telephone calls or requests for immediate decisions by subordinates? Is there a lot of change or turn-over in key positions? On the other hand, no change in senior management may indicate stagnation. Are the employees upbeat and positive?
Buyer’s Finances: Buyers should make sure that the “money is there.” Too many sellers take for granted that the buyer has the necessary backing. Sellers have a perfect right to ask the buyer to “show me the money.”
Marketing: Price increases may increase dollar sales, but the real key is unit sales. How does the business stack up against the competition? Market share is important. Does the firm have new products being introduced on a regular basis.
By doing one’s homework and asking for the right information – and then verifying it, buying a “pig in the poke” can be avoided.Read More
Take two seemingly identical companies with very similar financials, but one of the companies was worth substantially more than the other company. One company will sell for $10 million “as is” or some changes can be made and the same company can be sold for $15 million. Following is a partial list of potential company weaknesses to consider in order to assess a company’s vulnerability.
Customer Concentration: First, one has to analyze the situation. The U.S. Government might be considered one customer but from ten different purchasing agents. Or, GM might have one purchasing agent but be directed to ten different plants. One office product manufacturer with $20 million in sales had 75% of its business with one customer…Staples. They had three choices: 1. Cross their fingers and remain the same; 2. Acquire another company with a different customer base; or 3. Sell out to another company. They selected the third choice and took their chips off the table. The acquirer was a $125 million competitor which was unable to sell to Staples, so after absorbing the smaller company, the customer concentration to Staples was only about 10% ($125m + $20m=$145m of which $15 million was sold to Staples or 10+%).
Single Product: Perhaps the most famous example of a single product acquisition is when General Motors overtook Ford’s single product, the Model A, with Alfred Sloan’s brilliant concept of a different model for people with different financial thresholds. Henry Ford’s stubbornness to stay with one product (Model A) almost cost the company its existence.
Regional Sales/Limited Marketing: Companies with parochial focus have limited capabilities to grow other than within their own domain. A widget company with national and international sales has substantially greater prospects to grow than one limited to its own region.
Aging Workforce/Decaying Culture: Skilled workers in certain trades, such as tool and die shops, are not being replaced by the younger generation. This is a sign that the next generation will not provide the companies with a skilled workforce in certain industries.
Declining Industry: Some companies are agile enough to completely change their industry, such as Warren Buffet’s Berkshire Hathaway and Fashion Neckwear Company which completely changed from neckties to polo shirts.
Pricing Constraints/Rising Costs: Companies who sell a commodity product often lack pricing elasticity and are unable to pass on their increased costs to their customers. For a while, the steel industry was in this predicament, but through massive industry consolidation and a booming demand from China, the situation changed.
CEO Dependency/No Succession Plan: Many middle market companies have successfully been built up by the founder/entrepreneur/owner and some critics call these individuals a “one-man-band” for good reason. These superman types tend to dominate most aspects of the company, but this is no way to build a sustainable business long term. Furthermore, these CEOs usually have not created a succession plan.
If the owners of a company, many of whom may be outsiders, want to increase the value of their investment, they should, through the Board of Directors, try to overcome the company’s weaknesses. On the other hand, the CEO may not be either capable or motivated to do so. The alternative is to implement a CEO succession plan, preferably with the cooperation of the current CEO. Kenneth Freeman’s thesis in “The CEO’s Real Legacy” (Harvard Business Review, Nov 2004) is that the CEO’s real legacy is implementing a succession plan.
“Your true legacy as a CEO is what happens to the company after you leave the corner office.
“Begin early, look first inside your company for exceptional talent, see that candidates gain experience in all aspects of the business, help them develop the skills they’ll need in the top job…
“During good times, most boards simply don’t want to talk about CEO succession…During bad times when the board is ready to fire the CEO, it’s too late to talk about a plan for smoothly passing the baton…Succession planning is one of the best ways for you to ensure the long-term health of your company.”
Both buyers and sellers should assess the company’s weaknesses. While some weaknesses are difficult to overcome, especially in the short term, one potential weakness that is very easy to overcome is to implement a succession plan…especially during the company’s good times before things go bad and it’s too late.Read More