Financial due diligence is a surprisingly complex process and a key element of any M&A transaction, oftentimes enduring throughout the M&A process.  In this day and age, buyers and lenders are placing more emphasis on the financial due diligence component of the M&A process, and rightfully so.  With so much at stake in any M&A deal, there is no excuse for a lack of proper financial due diligence.

One area of due diligence that bears great weight is finding overvalued or undervalued assets as stated on balance sheets of the target company, and unrecorded assets or liabilities.  Areas that may be hiding undervalued assets include:

·               Property, plant and equipment carried at depreciated cost.  In today’s market, this may well be below market value.

·               Marketable securities usually reported at the lower of cost or market, which usually means a recorded value below current market rate.

·               Inventory recorded on the LIFO method.  Current replacement cost is usually higher.

·               Leases or debts at favorable rates.  These amount to unrecorded assets because the company’s effective liability is lower than normal.

·               Intangibles such as licenses, trademarks, customer lists, franchises and unpatented technologies.  Such assets purchased from others are generally amortized based on cost, which may be lower than fair market value.  Intangibles generated from within the company are normally written off as costs are incurred and may therefore be unrecorded assets.

While uncovering unrecorded assets may be a treasure chest for the potential buyer and lender, there may also be pitfalls in the form of overvalued assets hiding within the balance sheet.  Some potential areas of overvalued assets include:

·               Uncollected receivables that bear no interest or below-market interest.  This adds to the carrying cost of these receivables.

·               Obsolete or slow moving inventories.

·               Contingent liabilities such as threatened or pending litigation; employee benefits like severance pay, employment contracts and incentive contracts; obligations for product returns and discounts; product warranties; and guarantees of third-party indebtedness.

Not only does the due diligence process entail finding overvalued or undervalued assets and liabilities, but through the process one must also be on the look-out for revenues generated outside normal operations, including:

·               Litigation and insurance claim recoveries.

·               Reversal of accounting reserves for bad debts, obsolete inventory, litigation, etc.

·               Gains and losses from the sale of assets.

Many aspects of the financial due diligence process will be charged to an accountant, who will be a part of the M&A process as part of the buyer’s due diligence team.  In order to provide a forecast and various projections to the buyer and lender, the accountant will likely be involved in evaluating historic financial statements of the target company; identifying overvalued, undervalued and unrecorded assets and liabilities; assessing prospective future operating results and cash flows; evaluating and informing the buyer’s team of potential tax consequences, deal structures, cash flows, reporting requirements and general economic conditions in the particular industry; as well as many other important functions related to a potential transaction.  The forecast is a summary of the expected or most likely outcome of the acquisition.  It is the accountant’s best estimate of future performance, taking into consideration all relevant data that has been acquired about the particular company, its industry and general economic climate. 

However, things don’t always go as planned or expected.  In addition to the forecast, the accountant may also compile several “what if” scenarios, also known as projections, to look at various better and worse case situations different from the expected outcome.  The projections help the buyer manage risk, seeing the effect if certain risks or conditions come to fruition that are not expected to occur but are possibilities.  This gives a buyer an idea of the upside and downside of a deal, which will factor in to the price and terms a buyer is willing to commit to when making an offer for the company.

Financial due diligence can be a cumbersome and time-consuming process, but the payoffs are large.  The process screens out some transactions and re-prices others.  It shifts the emphasis from getting deals done to getting them done right, and that increases the chances of the transaction creating value, rather than destroying it.  Although the time element involved can become frustrating for all parties involved, it is a necessary component of any M&A transaction and should be viewed as a cornerstone of the entire transaction.  While each prospective buyer will have his own due diligence protocol, going about the process in his own unique way, the centerpiece of what the buyer seeks to ascertain is the same and can be summarized as, “Is this a good deal for me?”  While that is an overly-broad question, the key ingredients of what goes into that question are very similar, if not the same, from buyer to buyer.

Bill Decker has coordinated over 3,000 business transfers in the past 16 years.   Bill works out of VERCOR’S West Coast office.

Mark Gould is a VERCOR partner and co-founder, Certified Business Intermediary (CBI), Mergers & Acquisitions Master Intermediary (M&AMI), and Certified Business Opportunity Appraiser (CBOA). Mark is also a co-author of “The Business Sale … An Owner's Most Perilous Expedition.”  Mark has owned 10 businesses and has provided valuation, merger and acquisition services to over 500 companies in a wide range of industries.  Mark works out of VERCOR’S West Coast office.