Due diligence disasters- how to prevent in 3 easy steps ?

Imagine , we need to move from one country to another as there are better opportunities but we have a tedious and complex task like packing households , flying , unpacking.How do we feel ? Often times we get butterflies in our stomachs.A due diligence is no different.

I rememeber , how rigorous and boring a due diligence used to appear in the beginning for me. As I learnt to look the same complex subject with a new perspective,I comfortably applied for many purposes with great results.

Many times companies do not think through well guessing its just about creating a data room and responsibility of every one.The business envoronment has never been this dynamic before, so is the buyer’s mindset.50% of the M&A gets derailed affecting company’s aspiration and growth propspect through synergy.If a company is struggling for long , whats wrong in selling it off ? Similarly as a young company , if someone has done well , what’s wrong in encashing to start a new chapter ?

As soon as , companies learn how to be prepared to do a good due diligence ,it becomes much easier to sell or acquire a company regardles size or type of business.

How does due diligence help ?

Traditionally Due Diligince is part and parcel for a successful merger and acquisition , stock broking , investment risk analysis.However in a hindsight this is a terrific tool to understand a business holistically and run efficiently.

I am not from finance background.I will just share my experiences of business leading in take overs and management.Instead of stock investment , my perspective will be mostly from successful merger perspective and how a due diligence can help in usual management as a tool.I will also share what are the three approaches that makes due diligence simpler.

Merger Disasters

The instance of Due Diligence disaster is many. One such example is the M&A of HP & Autonomy.HP was on news when company acquired Autonomy for 10 Billion dollars in 2012. The management realised numbers were inflated by almost 8 billion dollars.

The situation is not diffrent with smaller companies or even considering a franchise business either.

I remember , many years before when I accompanied the Chairman of the board when he was scouting textile manufacturing assets in countries like Vietnam , India , Indonesia, Thailand.His vision was to grow fast by aligning running operations through M&A.

Lessons learnt

We were ready. Sellers wanted to make the transactions but could not meet the expectation of the Chairman.Or to put simplitically Sellers were not prepared enough.

We were bombarded with hard numbers ,data , files through the managerial staffs.But those were simply not enough to make an investment decision or risk analysis.

The chairman confided in me telling -”are we buying liabilities or assets “he is not sure and neither he could understand the baseline of fair value.As a business leader I was rying to understand deep about the future sketch and the available synergy. I could gauge neither.There was a lack of framework , holistic assessment , transparency.

From such experiences , I got utterly intrigued with due diligence later that it has almost percolated in my subconscious mind.Largely I have applied in assessing businesses quickly , making a growth plan , diversifying and definitely making the companies flexible to cease new opportunity of M & A.If I was entering into a sloppy bad water , I knew before.

To me a good due diligence should never leave the central sights like the fair value of the acquistion and the transparency of communication.Creating a frame work and the process of revealing data when it is actually needed proves beneficial. Buyers change mind quickly and does not want to swallow a liability.Transparent communication avoids the pitfall to create a trusting environmnet of negotiation.

The three simplistic approaches what I promised in the beginning are as below :

The three approaches : Hard Due Diligence , Soft Due Diligence and Mindset of seller

1.Hard Due Diligence.

The Business Model

Getting to know the busines model is to know that company can truly make profit or not whether its a start up or established company.It must look into business plan , markets , expenses , cost of goods in realistic manner.

Revenue and margin projection

The projection trend needs to take into account the parameters like competition,demand, economy.This can be a completely grey area. Walking with caution , asking critical questions is must.

The company capitalisation.( taking into account the parameters like volatility of the stock in the market , revenue streams will help immensely to understand the right capitalisation of the company. At this juncture KEY ratio analysis reflects lot of insights.My favorite is Enterprise Multiple. It is extremely handy to determine the growth potential of few companies within same industry eliminitaing the tax and interest burden and incorporates debt, available cash.The formula :

Enterprise Multiple = Enterprise Value ( EV)/ Ebitda

Enterprise Multiple = Market Capitalization — debt + cash available

Ebitda = Net Earnings — interest — tax — depreciation.

Higher Enterprise multimle means higher growth potential.

If the company is not in stock market , evaluate following to determine EV:

The present valuation of fixed assets ,

The present valuation of current assets ,

Another traditional parameters but utterly relevant factor are:

Examining the balance sheet

Review overall asset and liabilities with special empahsis on cash so that it can pay short term liabilities. Learn about long term debts.Many companies are highly capital intensive.Learn Debt / Equity ratio.

Evaluate intellectual properties which is intangible in nature like Patent , Copy Right , Franchises, Trade secrets.

2. Soft due diligence.

Getting to assess cultural clashes , systems compatiability , customer and vendor feedback, employee engagement, knowing key leader’s traits and drives.Inspite of having best of hard due diligence number and growth potential , it happens that many take overs capsize because of mismatch of cultural clash , leadership personality issuees , sellers involvement in politics or afflitaed business interst , team re organisation or may be potential lay off.

3. Mindset of seller.

Psychology comes into the picture in big way , specially with family run businesses .Understanding board , family , personalities closely makes a huge difference and unfolds lots of hidden stories relevant to business.Seller’s ego , attachment , syndrome like ‘my business is beautiful’are something we need to anticipate.A successful take over rests upon co-operative realtionship of the negotiating teams.

How complex a due diligence may be , the above three simple steps can assist creating a clear road map and adding upon further.

A good Due Diligence can not only save us from merger disater , it can support to manage a business efficiently whether it is start up , established , small or big companies in any sector.