Buyer tips for an effective M&A Financial Due Diligence process
In a robust market with aggressive valuation multiples and significant deal activity, Buyers need to remain honest with themselves and ensure that their due diligence processes are adequate in addressing deal risks. Here are some tips to Buyers to keep in mind when performing financial due diligence for a potential M&A transaction.
1. Prioritize diligence in terms of highest priority items first.
A Buyer should typically request 45 or more days to diligence a target company, and more time depending on the complexity and quality and pace of information flow. Due diligence information requests should always be prioritized and Buyers should always be thinking about critical issues. Similarly, since a Seller’s management and other resources are almost always information and time-constrained when balancing the burdens of due diligence requests and meetings with the challenge of completing their normal jobs, Buyers should know and communicate which information requests and questions are critical versus not critical to the ultimate investment decision.
2. Be skeptical of Seller EBITDA adjustments which are difficult to understand or for which the validation trail is unclear.
- Buyers should always think about the “board rule” – would I be able to easily explain certain Seller adjustments to my Company’s board of directors? Adjustments which are very difficult to explain should be met with additional skepticism.
- Just because a bank or lender accepts a definition of EBITDA and certain adjustments, this doesn’t mean that a Buyer should pay for an adjustment in terms of giving the Seller credit.
- Be skeptical of EBITDA adjustments which increase EBITDA due to future operational improvements. If such improvements are indeed so achievable, then why was the Company so inefficient in the past?
- Always be prepared to ask tough questions regarding Seller-proposed adjustments, rather than taking such adjustments at face value.
- Buyers should develop a plan to build out the capabilities received from the Target in the transition services arrangement (“TSA”) period, and make sure that the associated costs are included in the prospective financial model.
- If there are significant related party transactions historically, are such items already included in the historical financial statements at an arms-length rate? If not, does the financial model forecast arms-length expenses?
3. Thoroughly understand the nature of contingent obligations and the magnitude and probability of exposure amounts.
- Buyers should seek protections from cash obligations associated with potential liabilities, especially those which are not incurred in the normal course of operations.
- Buyers should seek to understand the accounting behind such obligations and understand if and how such contingencies are recorded in the Seller’s financial statements.
- Sellers will frequently state that certain obligations and contingencies will be settled prior to or at the closing of a transaction. However, Buyers should ensure that such items are indeed settled at closing, and that the purchase agreement does not inadvertently put the Buyer on the hook for such items.
4. Cash is king.
Companies should always focus on cash and timing and collections of cash. Items to consider include:
- If a Company’s DSO or DPO is increasing, Buyers should understand why this is the case and whether there are any significant red flags from the delay in cash collections and/or the Company paying vendors later than normal.
- Buyers should understand whether cash is reconciled monthly and whether equity rolls on the financial statements. If not, the risk of the validity and integrity of the financial statements significantly increases.
- Buyers should be skeptical of Seller EBITDA adjustments for which the Seller’s adjustments do not consider cash replacement costs. For example, if a Seller is capitalizing internally developed software costs, Buyers should ensure that the cash costs are picked up in their financial model. Similarly, if a Seller is adding back non-cash stock compensation, Buyers need to think through the post-transaction compensation plans and ensure that any incremental cash costs of replacing such equity awards are considered.
5. Perform sensitivities on assumptions and don’t hesitate to see how a Target’s past budgeting practices compared with historical results.
- Does the Target Company have a history of lofty budgeting and failure to meet such budgets?
- If in mid-year, Buyers should perform an analysis of current year progress against budget and understand assumptions used in the budgeting process in order to determine the depth of effort the Seller expends on budgeting.
- Buyers should perform an analysis aligning historical financials with the forecast, understanding the assumptions required to achieve forecasted results.
6. Judge the openness and integrity of the Seller and its Management.
- Does a Seller seem as if they are not forthcoming with information, or do they seem open?
- Is access to Management and information severely restricted without a legitimate reason? A Buyer should always ask themselves why this is the case and if the various pieces of information are adding up.
7. Thoroughly understand transaction perimeter and post-deal operations.
Buyers should always make sure they understand exactly which legal entities will and will not be included in the M&A transaction and should avoid making any assumptions. It is critical to verify that all relevant assets and people are included in the transaction perimeter and that no unnecessary legal entities (and thus potential obligations) are taken on. It is not unusual for there to be confusion regarding activities of included/excluded entities, especially in cases of complex legal entity organizational charts or unsophisticated sellers.
8. Proactively think about managing risk in an M&A transaction.
Buyers should take a step back and analyze where the greatest risks are in an M&A transaction and seek ways to address these issues. During negotiations of the Sale and Purchase Agreement, Buyers should carefully analyze disclosure schedules, working capital and purchase price mechanisms, and Indebtedness definitions. Further, Buyers should always engage in real-time dialogue with accountants and attorneys to determine how best to structure the transaction terms to minimize risk. Risk management mechanisms include:
- Earn-outs: Post-transaction payment mechanism which allows Seller to receive additional compensation if the Target achieves certain financial goals.
- Escrows: Cash which is set aside in order to fund potential contingent obligations.
- Representation and Warranty insurance (“R&W insurance”): Method for Buyers to obtain additional comfort over Seller representations via purchasing a policy from a third party insurance company.