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The Art and Science of Due Diligence
by Andrew J. Sherman,
Author of The AMA Handbook of Due Diligence

 
   
 
   

Due diligence is not just a process, it is also a reality test -- a test of whether the factors driving the deal and making it look attractive to the parties are real or illusory. Due diligence is not a quest to find the deal-breakers but a test of the value proposition underlying the transaction to make sure that the inside of the house is as attractive as the outside. Once the foundation has been dissected, it can either be rebuilt around a deal that makes sense or allow the buyer to walk away and prevent the consummation of a deal that doesn't make sense.

Overall, the due diligence process, when done properly, can be tedious, frustrating, time-consuming, and expensive. Yet it is a necessary prerequisite to a well-planned acquisition, and it can be quite informative and revealing in its analysis of the target company and its measures of the costs and risks associated with the transaction. Buyers should resist the temptation to conduct a hasty "once over," either to save costs or to appease the seller. Yet at the same time, they should avoid "due diligence overkill," keeping in mind that due diligence is not a perfect process and should not be a tedious fishing expedition. Like any audit, a diligence process is designed to answer the important questions, and ensure with reasonable assurance that the seller's claims about the business are fair and legitimate.

Proper due diligence involves knowing:

  • where to look
  • what to ask
  • what tools to use
  • who to ask
  • how to test premises/answers
  • who should ask

Effective due diligence is both an art and a science.

The art is the style and experience to know which questions to ask and how and when to ask them. It's the ability to create an atmosphere of both trust and fear in the seller, which encourages full and complete disclosure. In this sense, the due diligence team is on a risk discovery and assessment mission, looking for potential problems and liabilities (the search), and finding ways to resolve these problems prior to closing and/or to ensure that risks are allocated fairly and openly after the closing.

The "Art" of Due Diligence:

  • Understanding how to extract key information from a person or situation
  • Understanding the objectives of the parties and the underlying transaction
  • Identifying key hurdles and risks
  • Identifying why information might be falsified or omitted
  • Targeting the proper sources for disclosure of information

The science of due diligence is in the preparation of comprehensive and customized checklists of the specific questions to be presented to the seller, in maintaining a methodical system for organizing and analyzing the documents and data provided by the seller, and in quantitatively assessing the risks raised by those problems discovered in the process.

The "Science" of Due Diligence:

  • Do your homework
  • Be prepared and well-organized
  • Be precise in your requests
  • Be persistent in your quest for the truth
  • Don't accept the first answer as the final answer

Common Mistakes Made by Buyers During Due Diligence

  1. Mismatch between the documents provided by the seller and the skills of the buyer's review team. It may be the case that the seller has particularly complex financial statements or highly technical reports which must be truly understood by the buyer's due diligence team. Make sure there is a capability fit.

  2. Poor communication and misunderstandings. The communications should be open and clear between the teams of the buyer and the seller. The process must be well orchestrated.

  3. Lack of planning and focus in the preparation of the due diligence questionnaires and in the interviews with the seller's team. The focus must be on asking the right questions, not just a lot of questions. Seller's will resent wasteful "fishing expeditions" when the buyer's team is unfocused.

  4. Inadequate time devoted to tax and financial matters. The buyer's (and seller's) CFO and CPA must play an integral part in the due diligence process in order to gather data on past financial performance and tax reporting, unusual financial events or disturbing trends or inefficiencies.

  5. Lack of reasonable accommodations and support for the buyer's due diligence team. The buyer must insist that its team will be treated like welcome guests, not enemies from the IRS! Many times buyer's counsel is sent to a dark room in the corner of the building to inspect documents without coffee, windows or phones. It will enhance and expedite the transaction if the seller provides reasonable accommodations and support for the buyer's due diligence team.

  6. Ignoring the real story behind the numbers. The buyer and its team must dig deep into the financial data and test (and retest) the value proposition as to whether the deal truly makes sense. They must ask themselves, "Does the real value truly justify the price?" The economics of the deal may not hold water once a realistic look at cost allocation, inventory turnover, and capacity utilization is taken into account. 

(Excerpted from The AMA Handbook of Due Diligence by William M. Crilly and Andrew J. Sherman. Published by AMACOM Books, a division of American Management Association, New York, NY. Used with permission.  http://www.amacombooks.org.)


     
   
     
   

The Author

The AMA Handbook of Due Diligence

 

Andrew J. Sherman, is the author of several books, including The AMA Handbook of Due Diligence, Harvesting Intangible Assets, Mergers and Acquisitions from A to Z, Raising Capital, and Franchising and Licensing. He is a partner in the Washington, D.C. office of Jones Day and a top-rated Adjunct Professor in the MBA and Executive MBA programs at the University of Maryland. An internationally recognized authority on the legal and strategic aspects of business growth, he is frequently called upon by the media to share his expertise. He has been featured or quoted in The Wall Street Journal, USA Today, The New York Times, BusinessWeek, Fortune, Investor's Business Daily, Forbes, Entrepreneur, U.S. News & World Report, and other prestigious publications.

For more information please visit http://amacombooks.org/

     
   
     
   
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Copyright © 2010 William M. Crilly and Andrew J. Sherman. All rights reserved.

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