Importance of Financial Due Diligence in M&A

Introduction

  1. As more companies are paying astronomical prices to buy business, it is essential that the buyer completely understands the target business and the value that he is going to get on the Purchase price.This is even more important for companies involving emerging technology and digital businesses where the acquirer does not have much knowledge about how the digital acquisition is going to result in stable economic cash flows.
  2. The entire thesis of investing in digital companies is that the digital technology has the potential to improve customer experience or reduce cost of doing business by improving operating efficiency, but this assumption needs to be validated.This is substantiated from the market study that not all companies that have made investments in Digital Transformation have achieved success and expected revenues.

Information bias between the buyer and seller prior Due Diligence

  1. When the buyer expresses an interest to acquire target and proposes an indicative price range in LOI, the buyer still does not have complete knowledge on the business operations of target.The seller on the other hand knows everything about his business and may intentionally look to sugar coat his business by focusing on strengths and hiding any risks and vulnerabilities of the business from buyer in order to achieve high purchase price.
  2. Hence the buyer needs to be very careful on the information provided by the seller in CIM document and needs to challenge and validate every assumptions and data with the supporting documentation. If the buyer finds any discrepancies during due diligence, this will have a serious impact on the valuation.

Important activities to done by seller before Due Diligence

  1. It is evident that both the buyer and seller will incur costs on external consultants and investment bankers for due diligence.In addition, if the buyer finds out a major discrepancy while conducting due diligence which was not earlier disclosed by the seller, then this can bring trust issues which can further derail the momentum of the deal.This can affect the final purchase price that the seller will get and in worst cases may even derail the deal.
  2. In order to prevent this, the seller should do an exit planning exercise after he has decided to sell his business.The seller should hire a third party consultant/advisor to assess the risks and vulnerabilities in the way his business is run, how financials are presented and whether the quality of earnings is good.The objective of this exercise is to identify any threats or risks before these are identified by the buyer during due diligence and proactively look to mitigate this.
  3. The seller should realize that he would not be able to conceal any risks in his business and the buyer at all cases will identify any loop holes during due diligence. This exit planning will give idea to the seller to carry out activities to mitigate the risks before he engages an investment banker to find prospective buyers for his company.

Due diligence when the target is Public vs Private company

  1. The due diligence can differ when the target is public compared to a private company.
  2. In case of a hostile takeover, the buyer may not be invited by seller to conduct due diligence.In this case the buyer get all details from 10k reports and SEC filings on the target.
  3. In case of a normal M&A, if the target is comfortable with the price range given by buyer in LOI then the target can grant exclusivity to the buyer to analyse the documents in the data room at the top of the information already available publically.
  4. When the target is a private company then it is impossible for the buyer to do any due diligence without the support of the seller.The maximum thing that the buyer can do is to do a sector and industry analysis that the target is operating in to gather insights on the attractiveness of the market.Any data on the seller needs to be shared with buyer after signing the confidentiality agreement followed by the access to the data room post the signing of LOI.

What should be the scope of Financial Due Diligence?

  1. Before the due diligence commences, it is extremely important for the buyer due diligence team to know the structure of the deal, high level overview of the business, what is in the scope of the acquisition and what is outside the scope of the acquisition and the consideration of the transaction. In addition the team should understand strategic rationale behind the acquisition and potential deal breakers that could severely impact the purchase price or even the progress of the deal.This will help them to prioritize areas where they need to spend maximum time on.
  2. The Financial Due diligence activity is extremely laborious and time bound.The seller would ensure that the buyer does not take a lot of time to do due diligence. Even in due diligence, the information asymmetry between the buyer and seller would be there as it would be extremely difficult for the buyer to understand all aspects of target business along with risks at such a short period of time.Hence it is important the buyer prioritizes key areas that requires more time and analysis.

Some of the key areas to focus while conducting Financial Due diligence:
Detailed Analysis of Balance sheet, Income statement and Cash flow statement – The buyer should analyse the above statements in detail to identify the:

  1. Capital structure of the company in terms of ownership structure and debt.
  2. Historical revenues, Cost of sales, labour and material costs, Marketing, General and Administrative expenses.
  3. Top 20 customers by revenues along with revenues by service line, product and location.
  4. Key assets and capital investments done by the target company in recent years and how these assets are depreciated/amortized and whether these expenditure have generated expected revenues.In case of Technology company, R&D cost needs to be analysed and seen whether they are capitalized.
  5. Working capital requirements of the target company.This needs to be benchmarked with industry standards to check if the target company requires additional working capital.Clear analysis of Aging of Receivable and payables needs to be done to to identify whether the target is able to collect revenues on time from its customers.In addition, history of bad debts needs to he analysed and seen how target writes off bad debts and if sufficient provisions are there in current liabilities for the same.Aging of account payables needs to be analyzed to confirm if the target makes payments at right time to its vendors and whether the target has defaulted on payments to its vendors at any time.Inventory numbers also needs to be looked at to check if the target services are still in demand or if the target is finding difficult to replenish its inventory.This gives an idea to the buyer if the target services are still in demand from the customers.The outcome of this due diligence would help the buyer to arrive at the Target working capital or Working capital peg post closing.
  6. The pricing strategy followed by the target company to check if the target is able to command a premium price and if its service offerings are truly differentiated compared to its competitors. A market research along with competitors analysis is required to check the target company’s standing in the industry it operates in, its relative market share and if the service offerings provided are commoditized and if there is intense competition.In many cases, a political or macroeconomic change will increase the input costs of the services.In that case, it needs to be seen if the target is able to pass these costs to customer or if it absorbs these costs which would hit its margins.For instance in IT sector, due to strict Visa norms, more local employees are hired which increases the cost of services.In this case it is to be seen if the IT company increases its price to pass these costs or does not do due to fear of losing the customer to competitors.
  7. Capital expenditures analysis is required and seen if the target business requires additional investments to further scale and grow.This is important as it needs to be checked if these additional investments are required to be done by the buyer or has the seller already put in these investments.
  8. The buyer also needs to analyse the future growth projections of the target company and validate if the forecast projected by the company can be achieved.The buyer should also analyse the historical growth plans and confirm if the seller has been able to achieve the forecast.This gives an idea to the buyer whether the target has overstated the forecasts.In addition, the buyer needs to analyse the pipeline and order backlog to check the probability of achieving the projected revenues for the coming year.
  9. In many cases the seller would have adjusted the EBITDA in its forecast and assumed that there is additional scope of cost savings due to higher employee utilization or other factors in future.The buyer should question these assumptions as why the seller has not been able to implement those measures before.Hence the buyer should discount these adjustments in the Quality of Earnings study to arrive at normalized EBITDA.
  10. The buyer should also focus on the key employee costs and whether pension contributions are made by seller as per the local law.The buyer would not want to take liability on the underfunded pension contributions.In addition if any add backs are done on EBITDA then the buyer should validate the same.In many cases the buyer adds the owner compensation or stock payments to the EBITDA as the compensation earned by the owners would change post acquisition.The buyer should take into account the additional costs of the new employees that needs to be hired.
  11. Contingent Liability including any pending litigation claims or warranty claims needs to be identified and has to be settled by the seller prior to closing of the deal else the buyer needs to incur this liability in case of future payouts.

Transaction structure of Acquisition

  1. As more and technology deals stands the risk of meeting synergy targets ,the deal structure for most of the acquisitions have Earnouts and Retention payments as part o consideration.These are milestone payments which is paid to the buyer after achievement of target EBITDA and revenues.
  2. A part of the payment is put in an Escrow account where the buyer can withdraw the proceeds based on any future claims on the breach of representations and warranties. These provisions are time bound and is valid at most for 2 years post acquisition.

Conclusion

  1. Financial Due diligence is extremely important to give confidence to the buyer of the price been paid to the seller and if the seller business can generate expected future cash flows.
  2. In addition to the quantitative analysis done on the documents in disclosure schedule uploaded in the data room, the financial due diligence also involves qualitative analysis which looks at the internal controls of the target company, the quality of management team and how the financials are maintained and quality of the accounting systems/resources employed.This will give a perspective to buyer on the risks in the transaction and how it needs to be mitigated.


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