Due Diligence: Worth a Look?

Due Diligence (DD) is a handy, catch-all phrase used by Mergers and Acquisitions (M&A) professionals, to cover the data-gathering exercise which is a necessary precursor to any M&A deal.

DD is undertaken by the buyer in an attempt to gain an understanding of the business that it is proposing to acquire (target). It is also one of the key means by which the buyer will seek to gain information that it will use to negotiate the final price, a change in the terms of the deal, or both.

PRICE NEGOTIATIONS

Typically, the potential buyer will make an offer for the target that is subject to a range of conditions. Perhaps the biggest condition is DD. The offer price will be pitched attractively, of course, so that the seller is enticed to allow the buyer into the arena.

In spite of the fact that it always happens this way, the final price is more than likely going to be lower; and, that lowering is more than likely going to be the result of what is found in DD. I have never seen a price negotiated upwards as a result of issues emerging from DD.

STRATEGIC SECRECY

Traditionally, DD is a battleground. The seller wants to keep certain information away from the potential buyer until the latest possible moment. In particular, the seller will not want to disclose commercially sensitive information such as customer names and actual prices. This is more likely if the buyer is a trade, rather than an institutional, buyer.

Trade competitors often pose as potential buyers just to gather valuable information from the seller. In any event, if the seller reveals too much too soon, it can kill the value of the deal. Why pay for a business if you have just been shown all its secrets?

Another aspect of this competitive issue is the problem of multiple disclosures in the course of a sale exercise. If ten bidders see lots of juicy information, has the value of that information been diluted ten-fold?

After the deal is done and the business is sold, in spite of the confidentiality agreements that will have been made between the seller and the (nine) other potential buyers, those potential buyers will not be able to un-learn what they have learned.

They will know things, which, although un-useable in any overt way because of the confidentiality agreements, will be used covertly or even inadvertently. Such is the way of the competitive world.

BE PREPARED

Sellers should consider how much DD they should undertake before letting potential buyers anywhere near the target. The last thing the seller wants is a nasty surprise being discovered by a potential buyer as they sift through the DD material. I have been in one major deal where that happened and it is not pleasant.

The potential buyer was furious because they thought my client had deliberately tried to conceal something (which they had not) and the seller was furious because they lost the potential sale. The buyer walked away and months of work went into the shredder. The cause was sloppy DD on the part of the seller.

In fact, sellers should do more DD than buyers. The seller should know everything there is to know about the target, the buyer should only get to know a limited range of things. The seller should control the information flow. That is only possible if it knows what information exists.

CAVEAT EMPTOR

My view of typical, buyer-side due diligence exercises is that they are too broad and too unfocused on the real value issues underlying the proposed deal. That is, there is too much reliance on the volume of information that is requested and not enough consideration of the specific aspects of the business upon which the 'buy' decision is, was or will be based.

DD exercises tend to focus on the past (not least because there is a mass of information on that). How did the target perform one, two, three, or even five or six years ago? What are the accounts like for those years?

Some key issues, such as tax liability and other potential liability issues can be found in the historical paperwork. However, if the buyer is valuing the business on the basis of its future prospects, it should spend considerable time assessing whether the target has the ability to deliver on those prospects.

What is the condition of the machinery and equipment? What is the state of the order book and current contracts? What is being done towards R&D? What about target-customer and target-supplier relations? There is a host of forward-looking information which should be looked at in great detail but which is easily ignored or relegated to the 'if we have time' pile.

DISCREET DISCLOSURE

For the seller, DD is typically seen as a necessary evil. However, I think that there is an alternative view. While accepting that, for the reasons given above, full disclosure is not wise, the seller should consider whether more disclosure, rather than less, is good for both price and potential liability.

I have been involved in deals where the seller has said: "We will show you a considerable amount of detail and we will endeavour to answer all your questions," but do not then expect to be given a vast number of extensive representations and warranties in the sale / purchase agreement.

In addition, I have heard sellers say: "The price is this, you can walk away during DD, but you cannot change the price." I think that a seller can only take that confident stance if it has done its own DD. In addition, a buyer will only entertain that approach if it is allowed to undertake extensive and deep DD.

THINGS TO CONSIDER

In summary, both seller and buyer should think long and hard about DD. Sellers should consider the value and process implications of high-quality, pre-sale DD. Identifying all the skeletons in the cupboards, as well as all the potential gold mines, will (in either case) have a positive effect on the negotiations.

Buyers should consider: where is my value in the deal? And, why am I buying this business? History will be important. However, far more so will be the ability of the business to perform in the future, in the hands of the buyer and to the standard expected and paid for. DD should be directed towards those issues.