September 5, 2018 //
Implicit in our previous article’s discussion of the M&A pipeline is the need to move from a pool of initial candidates, often numbering 100 or more, to perhaps 1-2 good acquisitions. After high-level screens have weeded out the less attractive possibilities, and detailed analysis of publicly available information has further distilled the list, we may still be left with 10 or more companies of interest. This is the point at which the buyer initiates contact with the potential target company. Though the formal due diligence phase begins later with the signing of a Letter of Intent (LOI), it is useful to think of the process beginning during the pre-LOI discussions and exchange of information.
The purpose of due diligence is for the buyer to intimately and deeply know the target business – its strengths, risks, possible risk mitigation options, financial performance, growth potential, etc. This allows the buyer to know what they’re buying, price it properly, and for both sides to address key deal points right up front.
Effective due diligence requires the seller to share a great quantity of often sensitive information with the potential buyer – involving significant investment of time and effort on both sides. For that reason, we encourage in-depth sharing of real information pre-LOI. Post-LOI due diligence is about the confirmation of facts, not the seeking out of new ones. Tell them there are contracts pre-LOI; show them the contracts post-LOI.
When Stillwater works on a deal, we have a 95% close rate after an LOI is signed (the industry norm is around 50%). We recommend covering as many important business matters as possible before an LOI is signed, effectively eliminating surprises, increasing close rates, and shortening timelines. Specifically, we:
• Ensure that buyers are absolutely clear on their strategy and for the acquisition – and their consequent “must haves” and “deal breakers”. Then raise these items as early as possible in the discussions. Need strong IP protection? Won’t buy anything without a committed management team? Don’t proceed to the LOI if something essential is lacking or obviously amiss.
• Work with buyers to align their questions to their strategy and not get lost in the peripheral “nice to knows”. If you are buying a management team, you don’t care if they have 5 or 6 years left on a lease. Berkshire Hathaway’s Charlie Munger famously called hell in the corporate world “endless due diligence and no horse sense”.
• Help sellers manage their fear of sharing too much information. Clarify what truly is sensitive information and what is not – then plan how and when to disclose the most sensitive items. Don’t try to hide things. The truth will always seek you out.
Think of due diligence as a continuous journey of discovery – all information will come out eventually, the only question is when. Summarizing the key pieces of work at each stage:
Before first call with the company:
Objectives are to identify potentially good acquisition targets and eliminate the non-starters.
• Collect and analyze all the publicly available information.
• Develop a high-level understanding of the company, forming an initial hypothesis about its attractiveness and fit, and identifying areas for deeper inquiry.
Between first call and LOI:
Objectives are to determine fit, assess value to buyer, uncover and address potential red flags, and begin planning for the integration.
• Ask questions. Request information. Have conversations with target company management and meet with other key people where possible. Remember to focus on the “why” of your acquisition strategy, and don’t waste time on peripheral questions.
• Understand that sellers may not give everything, as some information is sensitive.
• Identify detailed evidence / confirmation you will need to see post-LOI.
• For the companies that match your “why”, be purposeful. Move forward with vigour.
• For the companies that don’t fit, find out and move on early – a quick no is better than a slow maybe.
Between LOI and closing:
Objectives are to confirm information gathered pre-LOI and complete the customary checks. Note that this is not intended as a mechanism to reduce purchase price.
• Perform formal due diligence. Every M&A advisor and frequent acquirer has their own checklist, with 80% of the questions applying to any acquisition and 20% being company- and deal-specific. Figure 1 shows some of the high-level areas we generally address and gives an example of the underlying detail.
• Confirm information collected pre-LOI.
• Complete the customary checks, including environmental assessments, litigation checks, contract reviews, and background checks.
A common mistake is to treat due diligence and acquisition integration as separate processes. In fact, the deep knowledge acquired during due diligence is vital to a successful integration effort.
The first article to really codify acquisition integration as a replicable rather than one-off process was Ron Ashkenas et al’s Making the Deal Real: How GE Capital Integrates Acquisitions. Lesson #1:
“Acquisition integration is not a discrete phase of a deal and does not begin when the documents are signed. Rather, it is a process that begins with due diligence and runs through the ongoing management of the new enterprise.” The authors go on to explain, “GE Capital found that being sensitive to integration issues during the due diligence phase began to foster better decisions about whether to proceed with an acquisition at all.” This realization has given rise to best practices including:
• Ensuring that key people serve on both the due diligence and functional integration teams.
• Explicitly connecting emerging due diligence findings to their integration implications.
• Collecting information during due diligence that will be needed to begin integration planning.
• Holding daily due diligence team check-ins to flag cross-cutting themes or issues.
In the next article we will shift focus from search to valuation, including how due diligence findings impact decisions about pricing and value.
For more information, contact:
Doug Nix, CPA, CA
T/ 905-845-4340 x.211
Stillwater Capital Corporation
2010 Winston Park Dr, suite 401, Oakville, ON L6H 5R7