Commentary & Analysis
Preparing to acquire: the basics of due diligence
If you’re acquiring a company, you better do your due diligence. But what does that involve? Patrick Henry spoke to two M&A experts to get the lowdown on how to ask the right questions. This is the first of a two part series; this one deals with inspecting the facilities and determining what kind of team you’re inheriting.
By Patrick Henry
Published: June 25, 2010
A web search for the term "due diligence" returns an overwhelming number of definitions, some straightforward, others more complex. But they're alike in describing due diligence as an investigative process that takes place in advance of a major business transaction, such as the acquisition of one printing company by another. The sources also agree that in performing due diligence, the buyer's goal is to determine how closely the condition of the acquisition target conforms to what the seller says it is - a determination that has to be made before a valuation can be established and serious negotiations can begin.
Representing New Direction Partners, M&A specialists Paul Reilly and Peter Schaefer have guided many acquisition-minded print company owners through the intricacies of due diligence. But due diligence at its most basic, they agree, is a common-sense exercise in asking the right questions about how the seller's company is run and what transitional issues the buyer would face if the deal were to go through.
Properly conducted, due diligence exposes weaknesses as well as strengths in the acquisition target, better equipping the buyer to decide what influence the findings should have on the terms of the transaction. Reilly and Schaefer say that a prospective buyer has questions to ask and facts to gather in five key areas of due diligence: facilities and equipment; employee relations; financials; customer base; and dealings with suppliers. Part 1 covers plant and staffing; financials, customers, and suppliers will be addressed in part 2, next month.
Facilities and equipment
Whether the buyer intends to occupy the space or not, a visit to the seller's plant is the first logical step in due diligence. A facility tour is an opportunity to inspect production equipment while it's running and to evaluate the overall condition of the plant. Reilly says that like all first impressions, cleanliness counts. "Cleanliness" in a printing plant means swept floors, clutter-free production areas, and zero tolerance for oil and dust - all indications that the workplace is one where attention to quality starts literally from the ground up.
Every printing plant operates under permits, and it's essential, Reilly says, for the buyer to confirm that the seller's are comprehensive and up to date. Current permits for effluent discharge - the air that leaves the plant from dryers and other emission-generating equipment - should be in place and available for inspection, along with MSDS and other paperwork for pressroom chemistry.
It also can be revealing to ask what kinds of measurement the seller applies in day-to-day operations. For example, accidents happen, and accident rates should be scrupulously tracked. Quality and productivity are measurable, and they should be measured. Reilly says, by accumulating data on yardsticks such as job rework rates, waste, machine uptime, and units produced per shift.
A plant with a centralized MIS that automatically collects data from production centers would be a best case in terms of measurement, but no matter what method is used, the timeliness and completeness of the reporting are the key criteria. If a measurement system is in place but not up to date, says Reilly, "that's a yellow flag."
If the plant is leased rather than owned, the terms of the lease have strong implications for the negotiations to follow. Schaefer says that when the cost per square foot is abnormally high or low compared with prevailing market rates, the difference represents an adjustment to earnings that the buyer will have to take into account when normalizing the rates after closing. This adjustment affects calculation of value.
Bearing in mind that the value of printing machinery declines fairly rapidly after purchase, the buyer can make that determination with the help of a qualified appraiser. Sometimes, says Schaefer, plant equipment is pledged as loan collateral, and sometimes it is subject to personal loan guarantees binding its owner to repayment as an individual. It's important to know that such arrangements exist, since they could complicate the seller's position during negotiations.
Obligations like these are a concern for both parties, says Schaefer, "because as a buyer, you have to make it possible for the seller to do the deal."
As for the equipment itself, says Reilly, it's vital to find out how well it has been maintained. Ideally, the plant should be following a formal maintenance routine with logs, checklists, and regularly scheduled downtime for machine inspection. Also desirable are maintenance contracts with manufacturers or third-party service providers.
Even in something as objectively considered as an acquisition, assets aren't everything - the human factor and the part it plays in valuation have to be taken into account as well. Schaefer and Reilly agree that because the quality of employer-employee relations has such an obvious effect on productivity, it deserves the same attention as anything to be found on the production floor or in the balance sheet.
Getting a handle on attitudes and morale isn't complicated, says Reilly - it's as simple as keeping one's eyes and ears open during a tour of the plant. Do managers and staff know and address each other by name? Do they appear to interact well? And what do workplace amenities say about how cordial or adversarial relations between the two sides really are?
According to Reilly, answering the last question can be as simple as looking in the bathrooms. If the executive washroom is a "palace" and the facilities for the workers are shabby, that could be a sign of strained relations that the buyer will eventually have to confront.
Apart from the condition of the bathrooms, says Schaefer, the first thing the buyer will want to learn about the workforce is its union status. In an organized plant, it's essential to know when labor agreements expire and whether strikes or other disputes have occurred.
Trends in staff turnover can also speak volumes about worker-management relations, Schaefer says. And if that turnover includes wrongful dismissals that could be contested in court, adds Reilly, watch out. "Employee liability is potentially one of your biggest headaches," he says, urging buyers to be vigilant for employee lawsuits, allegations of harassment, and similar incidents in the seller's history.
When reviewing compensation, salaries and commissions to salespeople and merit close attention. The buyer needs to know, says Schaefer, whether the seller's salespeople are paid on the same basis and whether a formal sales compensation plan is in place.
The absence of a plan isn't a deal-breaker, according to Schaefer, but it's still necessary to find out how close or far apart buyer and seller are in terms of sales compensation - a big difference might have to be reconciled after closing. Schaefer also recommends asking about non-compete agreements that may be in effect with the seller's sales staff.
Reilly agrees that a conflict in sales compensation strategies is a financial and a personnel issue to take seriously. Although the disparity can't be eliminated overnight, he says, it eventually will be necessary to have everyone in the combined sales force on more or less the same compensation plan.
Benefits packages for all of the seller's employees have to be compared with what the buyer currently offers, and if the seller's benefits are significantly more generous than the buyer's, says Schaefer, the disparity between the two will have to be adjusted in ways that could impact profitability. If the seller has a profit-sharing plan, the cost of providing that benefit becomes something else to factor into compensation planning.
It should be clear that in due diligence, one of the outcomes is the discovery of potential problems that, at first glance, might appear to be obstacles to ever getting the deal done. But these problems can be turned into opportunities, say Reilly and Schaefer, if the buyer understands them well enough to perceive the benefits that solving them will make possible. The overview will continue in part 2.