The Middle Market Review Insights on the Middle Market.
M&A due diligence is something that a buyer performs when seriously considering an investment or acquisition of a company. It’s like getting a mechanic to look over a used car before you buy it. The questions are even more or less the same: “Around how much should I pay?”, “Anything wrong I should know about?”, and “Will it last?”
We’ve previously written articles providing due diligence tips, and there are dozens of due diligence checklists available, with dozens of categories and hundreds of line items. But buyers really look for three things: exposure, sustainability, and “fit.”
Exposure encompasses every risk or threat the buyer can imagine. The most obvious exposure is litigation, either as plaintiff or defendant. What was the cause and what is the likely outcome? More specifically:
- The buyer is presumably impressed with your intellectual property (IP), but wants to know, is it protected? Is it patented? Are those patents at risk of being challenged or due to expire? (Patent expiry is how we get generic pharmaceuticals.) And have you taken pains to keep IP in-house, with technology measures and non-compete clauses?
- Is the company compliant with regulations and industry standards? Every company is subject to generally-accepted accounting principles and OSHA regulations, but a medical device manufacturer must live up to FDA regulations and industry-specific ISO standards. The short of it is–is the company a law-abiding corporate citizen?
Beyond litigation issues, the buyer will likely probe whether you have a reputation for being a good corporate citizen. The buyer will “Google” you, looking for grassroots campaigns and bad press. Reputation adds or detracts real dollar value; it attracts top talent, and certain customers factor in corporate social responsibility into buying decisions. A couple of boutique firms have evolved, offering “green diligence” and “corporate social responsibility” (CSR) audits.
The buyer will likely also ask about crisis preparedness: do you have a plan to prevent data loss, and to react if it happens? Are you insured against “Acts of God” and do you have contingency plans to continue operations? Do you have a PR firm on retainer should you suffer some blow to reputation?
The sustainability category of due diligence is all about your company’s ability to create enduring value and thus perform as a good investment for the buyer. Sustainability provides the buyer with the foundation on which to continue to build the business. Depending on your industry, sustainability can come in the form of intellectual property, customer retention, competitive landscape, and even your management structure.
Some things buyers will evaluate include:
- The buyer will look into your marketing plan, R&D or product development efforts and sales organization to ensure that you know your customers and your market.
- Know how to grow your business sustainably with new products.
- Know how to acquire customers repeatably with a trained sales organization and appropriate sales channels. They will review your customer base and contracts: ideally, purchase orders are predictable and growing and your customer retention or re-order rates are as close to 100 percent as possible.
- They will review your product portfolio, asking, do you have a history of updating your product line, and if you are a young company, do you have the R&D power to evolve?
- They’ll look at all your liabilities–the obvious stuff first, like vendor contracts, bank and non-bank contracts, customer warranties.
- They will look as well at benefits and compensation, including insurance and retirement plans and non-monetary compensations like company cars.
- They’ll look deeply into financials, both historic and forecasted; have you met your financial goals, historically? Are your forecasts in line with prior performance? Out of hundreds of line items, this one gets perhaps the highest scrutiny, perhaps because investors always pay a premium for a company that can generate predictable revenues and earnings.
In some cases, a buyer will acquire a company that fits so well with their existing business or portfolio, that your company requires little tinkering. Often times, the value of the target acquisition is not in the company, but the value is related to how the target adds to the buyers’ existing portfolio, either by leveraging the brand to expand into new product lines or buying into different stages of the product life cycle.
In this scenario, the buyer may elect to sit on the board and leave management intact, or you become a wholly-owned subsidiary with the only noticeable change being periodic strategic reviews. More often, however, an acquired company will undergo a period of integration to maximize “mesh,” and a buyer will be on the look-out for specific issues that may impede that process.
- Culture: The buyer will also look for a fit in corporate culture; this is not a “touchy-feely” factor, but a practical point. Salesforce.com CEO Marc Benioff prided himself on creating a “Mahalo culture,” with Hawaiian shirts as office wear and an office party every Friday. Benioff deflected buyers, recognizing that any VC or established software company would likely make him wear a tie.
- Cooperation: The buyer will look as well for cooperation. Any unproductive defiance tells the buyer you won’t fit the evolved organization. They need to know you can realign with post-purchase objectives; can you champion a new mission statement, and abandon pet projects with grace? (The only right answer, in both cases, is “yes.”)
- Human Capital: The buyer will look for a mesh with the human capital, asking who the top and bottom performers are. In a strategic acquisition in particular, they will also look for redundancy, identifying key areas where the buyer already has the organizational structure to execute on similar operations, such as accounting and information technology.
Transparency is crucial to trust. Bad news (a lawsuit, a patent expiry) may not be a deal breaker, but hiding it is. Tell the buyers all they need to know sooner than later, else those exposures become reasons to abandon the buy all together. Inherent in the whole diligence process is trust. The buyer wants to trust you, but will question every process and figure not as a matter of trust; rather as an experienced investor who knows what it requires to make an acquisition mesh.