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Financial Due Diligence a Key to Successful M&A

By James A. DeLeo, CPA/MST
Gray, Gray & Gray, LLP

Integrating two companies, either through a merger or when one entity is acquiring the other, is an extremely intricate process. There are many complex issues and tough decisions involved when considering a merger or acquisition, especially in today's economic environment.

Nothing should be left to chance. Regardless of the size of the transaction, there are risks that must be identified before the deal is completed. Tax, accounting, and business issues can make or break a merger or acquisition. Buyer and seller must each have a complete understanding of the business issues involved to arrive at the most favorable deal for both participants.

In the mergers and acquisitions world, due diligence is the single most important activity in the appraisal of a company. Any company that is considering a merger or acquisition should engage in financial due diligence (along with the more familiar legal due diligence) in order to explore compatibility or feasibility. Due diligence is the bridge between the letter of intent and a purchase and sale agreement.

Legal due diligence is a familiar process for most people. Engaging an attorney to examine a target company's legal standing, outstanding lawsuits, potential liability and contractual obligations is essential to any transaction.

A financial due diligence audit, on the other hand, is carried out to authenticate fiscal information about a company or a business, including its assets and performance. Due diligence uses external sources of information to verify reported facts or support certain assumptions on which financial projections may be made. This can include broad issues like actual and projected revenues, market trends, financial stability - all the way down to details such as billing rates, employee benefit costs or lease agreements in place.

The information gained through the due diligence process can not only serve to reassure the buyer, but may also provide additional information that could be valuable in the negotiation process.

The Due Diligence Process

The process of due diligence is carried out by a team whose members have expertise in various areas. This team may be a combination of internal members (CFO, controller) and external experts (accountant, banker). The team's task is to acquire and analyze documents that will assist in obtaining the desired information.

The due diligence process is generally accomplished in four steps. The first is identification, which involves information gathering. During this phase, the due diligence team spends time reviewing current operations and assembling documents and data.

The second phase involves examination of the information gathered, looking for potential liabilities, weak financial performance, and any other anomaly that might signal trouble.

The third phase involves summarization of the data collected and analyzing the information. How does it affect the potential merger or acquisition?

The fourth phase, consolidation, is performed after the merger or acquisition and involves combining operations and addressing administrative issues.

The acquisition of an architectural or engineering firm offers specific challenges.

When buying a firm, existing contacts and clients are an important issue. Request at least five years of detailed project reports.
Ask the seller to list his/her largest 25 clients. Buyer and seller should jointly call on the clients to discuss the pending sale of the existing firm and to introduce the new owners.
Require the seller to provide five years of financial statements, including IRS filings.
Examine any employment contracts. Make sure there are noncompetitive covenants in place prior to change of ownership.
Determine the true ownership of the business. Do the principals own the business or are there other investors involved?
Arrange for an escrow account so that audit changes can be accounted for.
Obtain an indemnification agreement from the seller for prior acts and make sure that the seller's errors and omissions policy provides for "tail" coverage.
Obtain employment contracts from the current owners or written agreement(s) that they will be available for a period of time.

Due Diligence Checklist

The following information should be gathered during the financial due diligence process:

Names of all operating entities with a list of owners and officers and ownership percentages
Most current audited financial statements
Most current annual report and Form 10K
Copies of current insurance policies
Details of any planned significant change in operations over the next year
All brochures, advertising copy, pamphlets, etc., used to describe the business
Details on any foreign operations
Copies of all leases and contracts
Payroll and number of employees by classification for next year
Federal Employer's ID# and SIC code
Gross revenues expected this year and next
Gross revenues for past five (5) years
Details on any discontinued product or service
List of all property owned or under current lease, including occupancy, type of fire protection, square footage, and construction

Look in the Mirror, Too

Due diligence should also be a period of self-analysis. The due diligence period is an excellent time to gather information, both externally and internally, to enable you to assess all of the risks associated with the proposed transaction. You should not only challenge the representations made by the seller, but also examine your own company's understanding of the targeted company. Ultimately, due diligence will reveal whether or not an acquisition or merger is appropriate.

Don't Rush to Judgment

While timing is often critical in a merger or business acquisition, moving too fast can have unintended - even disastrous - consequences. Relying on a cursory examination of a target company's books, or focusing your attention too narrowly on specific aspects, can result in a misleading picture. Instead, invest the time and money to conduct a disciplined, organized examination of all financial aspects. Such an approach will pay dividends in the long run.