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10 Keys for acquisition due diligence

Posted by AccountingWEB in on 12/18/2007 - 14:13 Printer friendly
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By Joe Michalczyk, CPA

The amount of global deals is growing at a staggering rate, increasing the need for thorough diligence. In
2006, global deal value surpassed the $4 trillion mark, up from $3 trillion in 2005. The number of
transactions increased globally from 35,329 in 2005 to 39,120 in 2006.

Last year, U.S.-focused funds raised an incredible $252 billion - $80 billion more than the amount raised
in 2005, according to Thompson Financial. This amount includes the $130 billion raised by U.S. venture
capital, buyout and mezzanine funds.

The increase in merger and acquisition (M&A) volume and available capital fosters competition for
transactions, creating a seller's market. However, with competitive bid dates, the time allotted for
diligence has in recent periods been reduced, increasing transaction risk. It is therefore imperative to
understand a company's fundamentals and value drivers, and arrive at an appropriate valuation that
thoroughly assesses the target company's health, investment prospects and transaction risk.

Successful buyers must be fully prepared to back up their valuation with realistic data and a solid action
plan, knowing the only way to win a deal is to understand a target's business sooner and more
completely than the competition.

Following are 10 key items of focus when performing due diligence on a company up for sale ("target").

1. Focus on cash flows/EBITDA: Prospective buyers typically base their bids on a multiple of a
target's cash earnings from operations or Earnings Before Interest, Taxes, Depreciation and
Amortization (EBITDA). When determining a target's normalized EBITDA or "run rate," the buyer
should exclude non-recurring, non-cash items such as gains or losses from acquisitions,
divestitures, discontinued businesses or fixed asset sales. Other items to consider include other
unusual and non-recurring revenue and expense items that may not recur, such as out-of-period
accounting adjustments, adjustments proposed but unrecorded by the company's auditors, one-
time revenues or expenses, and other non-cash items. In addition, changes in historical versus
prospective management compensation, major customers gained or lost and changes in historical
versus prospective ownership should be considered (e.g. public versus private company costs,
and stand-alone financial statements versus corporate allocations).

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2. Appropriate accounting policies: During diligence, consider the appropriateness of the

significant accounting policies the target applies when preparing its financial statements. Critical
policy areas generally include: revenue recognition (including sales returns and other reserves),
accounts receivable and other judgmental reserves and inventory costing (including obsolescence
and other inventory reserves). Changes in accounting policies, adjustments proposed only on a
quarterly or annual basis and the general financial/accounting control environment should also be
considered. In addition, due diligence should always include discussions with the company's
external auditors and a review of their working papers. Note that in certain instances, U.S.
Generally Accepted Accounting Principles (GAAP) financials may not be provided. On these
occasions, other supplemental procedures should be performed (an analysis of operating cash
flows, for example).

3. Historical revenue and cost trends: Buyers should always consider the target's key historical
revenue trends and whether or not they can be sustained. Diligence should include analyses of
historical revenue and margin trends by customer, product family/business, product line,
geography and distribution channel. Seasonality and customer concentration trends should also
be assessed. On the cost side, emphasis should be placed on analyzing supplier concentration,
sole source suppliers, new contract terms/contracts expected to expire, raw material costs trends
and trends in historical selling and administration, advertising and research and development
costs.

4. Consistency between historical results, versus budget and forecast: Once historical trends
are understood, the diligence team should assess the linkage between the historical budgeted
versus actual results to gauge the accuracy and reasonableness of the company's forecasts. For
example, if the target is forecasting revenue growth and margin increases, how successful has it
been at achieving this level of performance in the recent past? The buyer should inquire as to the
projected impact of new and unproven products. A forecast analysis should also include a review
of the components of projected revenue growth to ascertain if growth is heavily dependent on a
core group of customers or if any changes in recent periods might affect growth. Did prior periods
include restructurings? If so, were they successful, and are new "run rates" reliable? The buyer
should also consider analyzing gross margin and customer loyalty assumptions, as well as
forecasts relating to operating expenses (i.e. head count, capacity, etc).

5. Historical and anticipated capital expenditure levels: The buyer should determine if current
and planned capacity is sufficient to meet the target's forecasts. This should entail comparing
historical and projected capital expenditure levels, analyzing current commitments for future
expenditures and analyzing maintenance versus investment capital expenditures.

6. Quality of assets and working capital: The due diligence effort should include an analysis of
historical balance sheet trends, the composition of significant balance sheet accounts and the
quality of working capital. Normally, parties to a transaction negotiate a working capital peg in the
Sale and Purchase Agreement (SPA). This means both parties agree that a minimum dollar
amount of working capital will be delivered at closing. If the amount of working capital comes in
higher than agreed at closing, there is usually a purchase price adjustment favoring the seller. If it
comes in lower than the peg, the adjustment usually favors the buyer. Pegs are usually set based
on historical averages. However, when negotiating the peg, a buyer should also consider such
factors as GAAP adjustments, seasonality and recent business trends (e.g. increases in days

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sales outstanding and changes in customer/supplier terms). The expected timing of the closing
should also be considered when determining the appropriate peg.

7. Debt and debt-like items: The amount of financial leverage as considered in the buyer's model
may not only reduce purchase price, but also impact the selling price in the buyer's exit. There
may be liabilities a buyer may wish to consider as debt-like, and therefore, either exclude from the
deal or seek as a reduction in the purchase price. If debt is to be excluded from the transaction,
the buyer should ensure the definition of debt in the SPA is sufficient to require a reduction in
purchase price. Key items that could be considered debt-like in nature include operating or capital
leases, unusual provisions in employment agreements or purchase and supply agreements,
financial guarantees and other financial instruments, environmental contingencies, litigation and
acquisition earn outs.

8. Contracts: In performing diligence, the buyer should review key customer, supplier and
employment contracts looking for items such as change in control provisions, expiration dates of
the agreements and increases/decreases in customer/supplier pricing that differ from the
historical results. This work should be done in conjunction with the buyer's legal advisors.

9. Taxes: An analysis of a target should always include detailed tax diligence. Buyers should know
the expected tax structure of deal (i.e. if it is likely to be a stock or asset purchase) prior to
beginning the diligence process. Stock purchases generally require more analysis because the
buyer usually assumes all of the target's historical tax liabilities. In an asset purchase, by contrast,
most historical tax liabilities (other than transferable state and local tax liabilities that follow the
business) remain with the seller. In a stock acquisition, the buyer should assess the target's
historical tax exposures and its domestic and significant foreign income tax filings. Prospective
buyers should also contact tax authorities in the relevant jurisdictions regarding past
communications, obtain an understanding of transfer pricing policies on international sales and
assess any uncertain tax positions on significant transactions.

10. Other specialists on your team: A good diligence team should always include the appropriate
specialists in areas such as human resources, tax, insurance, management information systems,
commercial/strategy and industry-specific specialists. Acquirers should always coordinate their
findings with those of other advisors such as environmental and legal counsel.

This list is not all-inclusive, as certain commercial and regulatory issues are far more important in some
industries than in others. Therefore, prospective buyers should seek assistance from diligence
professionals who have the necessary industry expertise.

About the Author

Joe Michalczyk, CPA, is a director in the Transaction Services Group of PricewaterhouseCoopers, based
in Washington, D.C. He has nearly 13 years of diversified financial management experience providing
merger and acquisition advice, as well as finance and accounting services to publicly and privately owned
companies of various sizes and industries. Joe has worked on numerous large private equity, venture
and multi-national transactions during his tenure at PwC. Contact him at (703) 918-1480.

Reprinted with permission from the Virginia Society of CPAs.

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