03 Oct The Diligence Dilemma
Most investment bankers have lost a deal during the due diligence process, it’s the nature of the game. In fact, a large percentage of deals fail during the due diligence process. The frustrating part is this can often be avoided. In the SME space, selling a company is generally the deal of a lifetime; an exit, a chance to retire, the ability start something new. With this opportunity, comes weighty emotion. The due diligence process can be the difference between the success and failure of a deal.
This post discusses some of the common mistakes made during due diligence and provides suggestions on how to guard against them.
A keystone is at the apex of an arch, and communication is at the apex of due diligence. Communication is often neglected during due diligence. Establishing a solid communication channel is key and accomplished by sharing objectives before you start. Typical deals have multiple stakeholders, from lawyers to accountants. Each stakeholder has its separate apprehensions, and often focuses on this rather than the big picture. Forming a communication channel sounds simple, however both the buyer and seller want different outcomes from the due diligence process. A way to get around this is to develop a plan of key milestones, and meetings to assess the progress towards these milestones.
Two Bulls! All companies, small and large, should talk to experts when asking the question “how do I value my business?”. Valuation is an artwork not a science. More so, when emotion is involved both the buyer and seller need to step back, take a breath, and evaluate what their end goal is. It is often problematic to arrive at a fair valuation, and what sellers often forget is that your business is only worth what someone is willing to pay for it. An unrealised valuation is great, but this is what neither party wants. By definition a company is worth the present value of its future profit. But everyone knows it is more complicated than this. There are often non-tangible line items, for example estimated growth and uncertainties around contracts, and these often dominate the due diligence process. Large corporations use third-parties for aid and this is often in the form of expensive accountants, bankers, and other resources. A SME does not have this luxury and the owner is often thrown out of their comfort zone. The seller is generally an expert on their company, not valuation. The way to avoid this debate is, whether you are the buyer or seller, to keep the end goal in sight….the sale. While this may seem like a poster-child case for micromanagement, we have seen deals dissolve due to a disagreement over less than 5% of the acquisition price.
Death by provision
When evaluating the sale of a company there are many factors that need to be taken into account, these form the provisions. It is a skill to work out what items really matter. As with valuation, buyers and sellers often disagree on what is important. Too many provisions waste time, too little increase the risk for the buyer. Buyers need to take care, and think about the real risk they are exposed to. Ultimately, this should be determined by the buyer but outlined by the seller. A great way to reduce wasted time if you are the buyer is to get a decent understanding of the target’s industry before you start negotiations. You don’t want to be blindsided by issues (e.g. regulatory constraints) after you start negotiations. There is no “provision” checklist that you can tick-off, as every company is different. A simple rule would be that provisions with less than 1% impact on the sale value are not needed. The seller needs to make sure that the buyer feels that the risks have been accounted for. If the buyer is not completely comfortable the deal can fall over last minute. The best person the buyer can ask about the risks is the seller, and this is where communication and trust come into play.
No cookies please
A ‘cookie cutter’ approach to due diligence is a dangerous, but common practice. Buyers can sometimes be sloppy. Companies are complicated, and a standardized approach often leads to missed risks for the buyer, and missed opportunities for the seller. Sellers are the experts on their company and no two companies are alike. Just because you are acquiring a similar company, or more commonly a competitor, do not assume things about the organization. Common things missed using standardized approaches are:
- Regulatory conditions. These are often overlooked and can have substantial impact down the road.
- Product differentiation. It is common for a large FMCG to purchase a brand or product that is impacting its market share. However, every product is different and the seller needs to work out what is making it succeed. Could purchasing it affect the brands image?
- Customer concentration. One large customer affords positive and negative implications. While such customers require less overall maintenance where, there is greater risk if they leave. It is also common for customers leave after acquisitions occur. If you are a buyer examine the customer contracts. If no contracts exist, add them to the provisions.
- Key person risk. Often the case in a small business, businesses with complex products/services or specific IP. While this will need to be in the provisions, it may also be wise to purchase things like key man insurance.
- Customer payment cycles. Small companies often have an array of customer deals. This is because as small companies grow, and as they need new business, they become less consistent on payment terms
The last 5% takes the longest
One of the most common reasons due diligence falls over, according to Andrew Cagnetta (President of Transworld Business Advisors) is that the buyer uncovers an issue which the seller did not disclose earlier. Nobody likes being blindsided, in particular in the final hours of a deal when stress is high and most parties are exhausted. Surprises tend to lead to last minute consultation, which leads to unexpected costs that could have been avoided. Intellectual property, goodwill calculations and customer information are some common factors people leave to the last moment to clarify. The best way to avoid surprises is doing your homework. This is a common but hard issue to overcome, things will always be overlooked. The key here is for both parties to be upfront as soon as they see something that is missed. If you have made a mistake, don’t try and slip it through, it could cost you the deal.