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Why a due diligence review is essential in a business acquisition

September 20, 2016
by Mark Borkowski

Our group, Mercantile Mergers & Acquisitions Corporation, has been exclusively involved in the mergers & acquisitions business for the past 34 years. In 2016, we have seen more mid-sized, mid-market-based architectural businesses that want to exit the business than we have ever seen before. They want to sell, but it only starts there. Detailed information about the company and finances has to be provided.  This is called Due Diligence. 

When you consider acquiring a business, it is essential that you engage a professional with the necessary expertise and experience to perform a due diligence review (DDR). This will always significantly reduce your risk. “I have, on many occasions, found sufficient evidence in the review process that resulted in my clients withdrawing from the deal,” says James Phillipson, a founding principal of Mastermind Solutions Inc. “My findings convinced them of evidence of potential loss of their entire investment. In addition, there is often additional information that warrants an adjustment to the purchase price and the terms in the letter of intent”

The letter of intent (LOI) sets out the key terms of the offer that includes the right to do a DDR. Even where the LOI is binding on the purchaser, a DDR is essential, as it provides the purchaser with a wealth of information about the business that reduces the risks in every acquisition and enables the purchaser to plan for the numerous aspects of the business they will soon be managing. A lawyers’ review of the legal documents and agreements should not be considered equal to or be replaced by a DDR. A DDR is much more comprehensive and reviews many strategic areas of the business.

What is included in a DDR?

A comprehensive DDR will cover all aspects of the business that are likely to entail risk for the purchaser. The reviewer team leader will discuss with the purchaser the scope of the DDR, such as the aspects of possible concern that are to be covered or excluded. An extensive checklist will be utilized to ensure that no material is omitted.

It is not uncommon for a purchaser’s staff to participate in the DDR. In some cases specific technical expertise is necessary to perform the review or detailed information will be obtained to facilitate transition after closing. Also, the purchaser may want to include staff to manage the cost of the DDR.

The DDR commences with obtaining a list of documents and other material that can be anticipated. During the process, the reviewer will review documentation and provide copies thereof for the purchaser’s lawyers and other specialists, in preparation for the agreement of purchase and sale.  In addition, the reviewer will often adjust the normalized earnings that have been used in the calculation of the purchase price and refine any forecasts that have been prepared by the purchaser of future earnings, cash flows, working capital required and other key metrics.

“The savings in costs, combined with the benefits of having a list of issues that need to be managed, will exceed the cost of the DDR,” says Phillipson

Preparing for a Due Diligence Review

“In the ongoing day-to-day running of a business, many potential obstacles may have been accepted by the current owners and are not top-of-mind, but will likely be discovered in the DDR process. The seller can obtain a much better outcome by determining the likely issues and strategizing and preparing for a smoother DDR,” says Phillipson. 

There is a large amount of documentation, (hard copy and electronic) that is required for a DDR, regardless of the size of business. Murphy’s Law dictates that a DDR will interfere with some month-end, quarter-end, year-end, budget preparation, vacations, and so on, but preparing in advance by anticipating what will be required is going to facilitate a smooth process with a minimum of delays. The management team should assemble a data room or space for all the documents that are likely to be required by the DDR.

In preparation for annual financial statements, many mid-sized businesses allow for the accounting processes to stop short of the adjustments that will be provided by the external accountant. Where these entries include a routine “clean up,” this can delay the DDR as the reviewers calculate the true results and cash flows. The pre-DDR will identify the adjustments and implement processes to ensure that these become part of the routine accounting to avoid delaying the DDR.

In addition, the DDR consultant will report back to their client, the potential purchaser, on all that they discover so it makes sense to be prepared. “In many mid-sized businesses three factors often have not kept pace with the growth of the business: descriptions of responsibilities; approach to documentation; and processes. These will reflect on the quality of management,” says Phillipson.

A pre-DDR review will identify many areas of weakness and give the selling management an opportunity to take steps to remedy the issues so that they will no longer become issues during the DDR. The quality of management, processes and controls will inevitably influence how readily documentation is available at the outset, how the issues that arise and requests for additional documentation are dealt with and the perspective gained in reviewing the material provided. This will speed up the DDR and reduce the risk of the issues giving rise to renegotiation of the purchase price.

Of course there will always be issues arising in a DDR, in fact many. How the vendor responds can have a material impact on the results. Preparation for a DDR reduces the risk of the DDR continuing for a longer period which has a much larger impact on the seller than the purchaser. It is common for the vendor and their staff to allow the day-to-day operation of the business to slip. They might be de-motivated as they anticipate a change in management and staffing and are overworked or feel scrutinized as they attend to the many issues that arise.

As a DDR extends over a period, from a few weeks to a few months, the reviewer will maintain a vigilant eye on the key performance indicators of the business. If they start slipping it will provide fodder for the purchaser to renegotiate the purchase price to reflect those lower results and the increased risk to the purchaser.

What happens when a DDR does not run smoothly?

The reviewer may find significant and unexpected issues that the vendor cannot quickly resolve. The purchaser will be provided with a report setting out the issues and the expected impact, along with possible steps to mitigate, for example renegotiate the purchase price or abandon the acquisition.

How the vendor responds to issues found can have a material impact on the result as the items accumulate. The risk of the DDR continuing for a longer period than anticipated usually has a much bigger impact on the seller. It is common for the vendor and their senior staff to neglect day-to-day operations of the business, as they attend to the issues that arise out of a DDR.

A DDR that extends over a period will maintain a vigilant eye on the key performance indicators of the business and if they start slipping will provide fodder for the purchaser to renegotiate the purchase price to reflect those lower results and the increased risk to the purchaser. 

Conclusion

A DDR is an essential part of the process in acquiring a business. A professional reviewer will always find issues by digging through the records and using their business experience. The result of the review will impact the purchaser by providing information to be used in finalizing the acquisition and facilitating a smooth transition and mitigating risk.

Mark Borkowski is president of Toronto-based Mercantile Mergers & Acquisitions Corporation, specializing in the sale of Canadian mid-market businesses. He can be contacted at http://www.mercantilemergersacquisitions.com/



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