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Assembling Your Due Diligence Team

Mike’s Molding manufactured parts for the appliance industry. He saw an opportunity to add customers and product offerings by acquiring Irwin’s Insert Molding, an insert molder from whom Mike had bought electrical connectors for several years. Irwin told Mike he wanted to pursue his dream of moving to St. Thomas and running a charter fishing boat and so was ready to sell. He provided Mike with several years of financial statements showing the company made average profits and had a strong balance sheet. He told Mike they were not audited as Irwin had no debt and so his bank did not require an audit. Mike reviewed the financial statements and toured Irwin’s operations. Since Mike had done business with Irwin for several years he knew the business fairly well. There had been occasional late shipments and double billings, but Mike saw this as an opportunity. He was sure he could run the business better than Irwin had and make even more money than Irwin. They agreed on an all-cash price and Mike bought the business.

One month later there are raw-material shortages, suppliers who refuse to ship without cash in advance, and customers who refuse to pay for current shipments because of problems with product shipped before Mike bought the company. To make matters worse, Mike has had to divert management time and capital from Mike’s Molding to deal with the issues at Irwin’s Insert Molding. After several months of headaches Mike suspects that Irwin might have been less than honest in his depiction of the business and in the financial information he provided. 

While the names have been changed, this is a story I have lived through with a client referred to us for help after he had bought a business from someone he thought he could trust. Mike had purchased other businesses prior to this and so thought he had a good handle on how to do it. But with this transaction not only was Mike in danger of losing the money he had paid for the business he bought from Irwin, but his other businesses were in danger of collapsing from the financial and management strain. How could Mike have avoided this disaster? Before he closed the deal, Mike should have assembled the right team to perform proper due diligence on Irwin’s Insert Molding. Due diligence would likely have uncovered Irwin’s problems before they became Mike’s.

Acquiring a business is an undertaking best approached with care and planning, regardless of the size and how well you think you know the seller. Bernie Madoff was able to swindle others out of billions by getting people to trust him and drop their guard. A swindler who nobody trusts isn’t likely to dupe very many people. 

Fraud, while a real possibility, isn’t the only thing you need to be concerned about. There is room for honest mistakes and disagreements. Unpleasant surprises, such as an undisclosed lawsuit or environmental problem, sometimes pop up. Also, issues such as software systems that will not work together or differences in cultures and benefits can make integration of the purchased business into existing operations difficult. While due diligence cannot guarantee that none of these things will happen, it can greatly improve your chances of success in an acquisition.

Due diligence helps to protect you against unknowns. Its purpose is to verify that what you have been told is accurate, that what you think is accurate, and that there are no skeletons in the closet. 

In order to undertake due diligence successfully, you must assemble the right team. Who is on the team will depend on a lot of things, such as the type of business you are buying, the size of the transaction, your familiarity with the target company and its industry, the quality of the information you are provided, and the level of analysis undertaken prior to issuing a letter of intent. It will also depend on what you are buying. If you are buying assets as opposed to stock, for example, you might be able to dispense with or go more lightly in some areas. Also, who is on the team will depend on what you are attempting to accomplish with the acquisition. Are you trying to add customers? Manufacturing capabilities? New skill sets? For example, if you are attempting to acquire manufacturing capabilities you might spend more time and effort on assessing the quality of maintenance and have more need for manufacturing engineers on the team than if you were trying to acquire new customers and did not need the extra capacity.

Who should be on the team also depends on the skills of each team member. Depending on the transaction and the professionals involved, some team members might be able to wear more than one hat.

Some of the professionals commonly found on a due diligence team and examples of what they might do include the following:

Investment Banker — If you utilized the services of an investment banker to find the target and to negotiate the deal, you should consider making them part of your due diligence team. The investment banker will already have a lot of knowledge about the target, and will understand what has been negotiated and what is and what isn’t part of the deal.

Attorney — The attorney is the professional primarily responsible for assessing legal risks. For example, he might assess legal risks, such as the potential for product liability or the potential for lawsuits and successor liabilities. The attorney might also look for undisclosed liens on assets. The attorney will make sure the business is in good standing and that all legal documents, such as necessary board minutes and regulatory filings are in good order. If issues are uncovered, the attorney might need to enlist the aid of specialists, such as an attorney who specializes in intellectual property to help with patent issues or a labor attorney to assist with union issues. The attorney will also draft or review the sale agreement to be certain it properly reflects the deal as negotiated and protects you against known and unknown liabilities. An attorney should be part of virtually every due diligence team.

Accountant — The accountant will review financial records and, sometimes, operational records. He might look for unrecorded liabilities and verify that accounts receivable and inventory are accurately stated. He might also verify that product costs and gross margins are accurately stated, for example. Your accountant might also advise you on the tax aspects of the transaction. An accountant is an important part of virtually every due diligence team.

Environmental Consultant — Given the potential large liabilities for environmental issues, an environmental consultant is often utilized. If the purchase of real estate is involved, it is a good idea to involve an environmental consultant. If you will rely on bank financing, your lender will probably require it.

Operational or Manufacturing Consultant — A manufacturing consultant might review operations to help you assess the quality and efficiency of operations. Consultants might assess such things as compliance with industry standards, such as ASME, ISO, or QS standards. A manufacturing consultant might also examine ERP systems to determine what it will take to integrate the target’s systems with yours. They might also look for cost savings that you can implement once you purchase the company.

Engineer — An engineer might examine a building for structural soundness or to determine if it is suitable for the uses to which you intend to put it. A structural engineer or other professional might also carefully inspect the building to see what repairs will be necessary and to estimate the cost. An engineer might also examine equipment to be sure it is in good working order and to alert you of any necessary repairs or upgrades.

Other Professionals — Other professionals might be hired depending on circumstances and what is discovered during due diligence. For example, if you have concerns about whether local ordinances will allow you to move your operations into the target’s facilities, you might hire an expert in that area.

Regardless of who is on the due diligence team, it is imperative that you understand each professional's responsibilities. You must also confirm what will and won’t be done. Don’t assume. Ask a lot of questions. Meet with your team and discuss what needs to be done. They can advise you as to what needs to be done, but ultimately, you are the one who will live with the results. It is also helpful to have an advisor you trust implicitly who is experienced with transactions to help you be certain that all bases are covered. (See Listen Up! You Paid for Advice, Now Take It) That professional might be your attorney, accountant, or very likely your transaction advisor. 

Things will move quickly. This is not a time for your long-time accountant or lawyer to be learning about transactions. A lot is at stake — potentially the future of your company. It is imperative that you hire professionals with transaction experience. Your long-time accountant’s or attorney’s experience with you and your company can be helpful in getting a deal done, but if they have not done transactions before they should be supplemented with professionals who have transaction expertise and experience.

Due diligence cannot unearth every issue or potential liability. There is risk in any transaction. However, if you undertake your due diligence with proper care and enlist the right team, you will dramatically improve the chances that your transaction will be a success.

Patrick F. McNally, Partner in Charge of Corporate Finance Consulting, Blackman Kallick. Pat specializes in buying and selling businesses, valuation, analysis, and planning. Pat can be reached at 312-980-2934 or pmcnally@BlackmanKallick.com.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.