Acquisitions and Mergers

We prepare a report of due diligence based on the following

General Check List

  • Why selling? There must be a good reason why the owners of a business want to sell it – and they may be excellent ones, such as raising funds for an estate tax payment, a divorce, or retirement. However, there may also be hidden reasons as well.
  • Prior sale efforts- Have the owners of the target company attempted to sell it before? If so, find out what happened. Former prospective buyers are unlikely to talk about the issues they encountered, but an ongoing series of unsuccessful sale discussions probably point toward underlying operational, risk, or valuation issues that must be uncovered.
  • Business plans- Obtain a copy of not only the most recent business plan, but also the earlier versions of it for the past few years. Our team would persue these documents and compare them to the company’s actual performance and activities, to see if the management team is capable of implementing its own plans.
  • Complexity- How complex is the business? If it involves a large number of disparate subsidiaries that deal with many products and services, it may be too difficult for the acquirer to manage the operation. These types of businesses are also difficult to grow. Conversely, a company with a simple product line or service is an excellent acquisition target.
  • Ease of entry- Is this an industry in which competitors can enter and exist easily, or are there significant barriers to entry? Has there been a history of new competitors arriving and taking significant market share, or does market share appear to be locked in among the current players?
  • Related acquisitions- Have there been other acquisitions in the industry lately? Have other businesses put themselves up for sale? What is driving these trends? It is possible that the industry is going through a period of consolidation, which may impact the price the acquirer offers to the target company.
  • Reporting relationships chart- Obtain or prepare a chart that states the reporting relationships within the business. This is useful for determining which managers are in charge of which sections of the business, so that the team knows who to contact for more information. It also tells the team who to investigate for roles in the business if the acquisition is completed.

Payroll Due Diligence

  • Types of employees- Obtain information about the number of employees in the various functional areas of the company, such as production, materials management, accounting, treasury, and so forth.
  • Total compensation- Compile the total cost of the top employees. This means not only their base pay, commissions, bonuses, stock options, and payroll taxes, but also benefits and any reimbursements for a variety of personal expenses.
  • Pay level philosophy- What is the company’s philosophy for the level of compensation it pays to employees? Is it near the median pay rate for most positions, or substantially higher or lower?
  • Pay history- Construct a chart detailing the last date when each person was given a pay increase, and the amount of the increase.
  • Pay freezes- If the target company has been in financial difficulty recently, it may have imposed a pay freeze on its employees, with the promise of immediate increases as soon as the financial situation improves. This creates an expectation that the acquirer will immediately increase pay.
  • Employment agreements- There may be agreements with some employees, under which they are entitled to a certain amount of severance pay if the company elects to terminate their employment. The team should locate all of these agreements and document the amount of severance payments, in case the acquirer decides to eliminate their positions or replace them as part of the acquisition.
  • Discrimination claims- Are there pending discrimination claims against the company? Has there been a history of such claims in the past? If so, are the claims related to a specific person, or are they spread across the management team?
  • Employee manual- Always obtain a copy of the employee manual. It should contain a number of policies that impact the costs associated with employees, such as vacation and sick pay, vacation carry-forward, annual reviews, jury duty, military pay, bereavement pay, severance pay, and so forth.

Employee Benefits

  • Benefits- What medical insurance is offered to employees, and what portion of it must be paid by the employees? Is any insurance also offered to retirees? How do these benefits compare to what is offered to employees elsewhere in the acquirer’s businesses? Is the standard amount of benefits offered in the target company’s industry different from what is offered in other industries in which the acquirer competes?
  • Pension plan funding- If there is a defined benefit pension plan, ascertain whether the plan is underfunded, and if so, by how much. Also, review the funding assumptions used to derive the level of funding; it may contain optimistic assumptions concerning the future return on investments that are unlikely to be achieved in practice.
  • Vacations- Determine the amount of vacation time to which each employee is entitled, and how that compares to the industry average and the company’s stated vacation policy.

Annual Reports

  • Annual financial statements- Ideally, there should be financial statements for the past five years, which the team should translate into a trend-line comparison for the full five years.
  • Cash flow analysis- A key part of the financial statements is the statement of cash flows. This document reveals the sources and uses of cash. Be mindful of the information in this report when you are reviewing the income statement, for the target may report substantial profits even while burning through its cash reserves.
  • Cash restrictions- Is cash restricted from use in any way? For example, the local bank may have issued a performance bond on behalf of the company, and has restricted a corresponding amount of the company’s cash. Another example would be a cash restriction in order to fund a letter of credit.
  • Expenses categorized as non-operational- A company may shift expenses into a non-operational expense category, such as financing expenses, in order to make its earnings from operations look more impressive.
  • One-time events- See if there were any operational events that are unlikely to occur again, and strip them out of the results of operations. This is a common problem for one-time sales to large customers.
  • Disclosures- Audited financial statements should include a set of disclosures on various topics. The team should review these disclosures in detail, since they can reveal a great deal more information about a company than is shown in its income statement and balance sheet.
  • Public filings- If a company is publicly-held, it must file the Form 10-K annual report, Form 10-Q quarterly report, and a variety of other issues on the Form 8-K. All of these reports are available on the website of the Securities and Exchange Commission.
  • Management letters- After an audit has been completed, the auditors sometimes compile a set of recommendations into a management letter, which they distribute to the CEO and audit committee. Any such letters issued for the past few years are worth reading, since they contain suggestions to rectify deficiencies found in the company’s practices.