Make Sure The Price Is Right — November 2016

As we have noted in past posts, growth can often be achieved through acquisitions. In addition to business issues (market expansion; cost savings; and supply chain improvements) and legal issues (representations and warranties); an accurate valuation is a critical consideration. A key process in assessing the accuracy of the valuation is due diligence. In our view, the CFO should quarterback this process.

Due diligence is the process by which a firm confirms its assessment of the quality and value of a prospective acquisition. Specifically, this effort entails the evaluation of the company, corroboration of information, and verification that the target complies with established criteria the firm has set for its acquisitions targets.

The building blocks of the due diligence process include planning, macro elements, and micro elements. Planning entails the scope of the due diligence and coordinating the efforts of relevant management and professionals. Macro elements are concerned with items such as competitive position and quality of management. Micro elements consider specific measures of the target’s operational performance.

The key aspects of the planning stage involve establishing scope, determining the appropriate third party professionals, and site visits. The scope should focus on all aspects of the business with emphasis on the potential for BIG problems. Accordingly, certain professionals must be hired to detect such problems. We believe the key professionals in this respect are attorneys, actuaries, tax experts, and accounting professionals. Site visits should target the corporate offices and branch operations that in aggregate produce over 50% of revenue. Such efforts will require confidentiality agreements and confirmation with the target that employee explanations are accurate. We also think that the assessment of the respective cultures of the combining firms is important and should involve the acquirers’ CEO.

Major features of the macro element effort include analysis of the competitive position and evaluation of management. Key in this effort is the identification of red flags such as fraud; lack of management candor; loss of key suppliers and/or employees; willingness to provide important information; desire of key managers to leave after the transaction closes; and loss of major contracts. Important factors to investigate when evaluating management include:
• Credibility
• Experience
• Communication Skills
• Style
• Planning and Execution
• Credibility

Analysis of competitive position should concentrate on factors such as:
• Data From Which to Discern Economic Trends
• Industry Life Cycle
• Industry Concentration
• Principle Competitive Forces
• Structural Changes Affecting the Industry

The micro elements of due diligence entail analysis of the company’s operational effectiveness. This effort determines how various aspects of the target’s operations affect cash flow. One tool used to help make this determination is ratio analysis. Others are cost benefit analysis, as well as metrics such as revenue per employee, profit contribution by product line or geographic location.

A more detailed analysis should be utilized to make sure cash flow is accurately depicted and no sudden decreases loom. This effort includes focus on earnings quality; tax exposure; and IT integration. Earnings quality entails normalizing EBITDA for items such as missed accruals, “one off” transactions, and atypical accounting policies. Tax exposure requires utilizing tax experts to determine if hidden or unknown tax liabilities are extant. IT integration involves investigation to be assured that appropriate compatibility, security, and level of documentation necessary for combining the IT systems of the respective firms exists.

As we have noted in past posts, growth can often be achieved through acquisitions. In addition to business issues (market expansion, cost savings, and supply chain improvements); and legal issues (representations and warranties); an accurate valuation is a critical consideration. A key process in assessing the accuracy of the valuation is due diligence. In our view, the CFO should quarterback this process

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