By James Cassel
In 2011, Hewlett-Packard acquired a company called Autonomy for over $11 billion. Unfortunately, after the acquisition, HP found out that Autonomy’s management had committed fraud. For years, prosecutors alleged, Autonomy had been cooking the books ultimately resulting in HP being swindled and lots of litigation. It’s a great, albeit costly, lesson on the importance of proper due diligence.
The amount of due diligence needed when purchasing a company is a balancing act. One has to take into consideration the available resources. You often have to decide whether to drill deeper when a red flag arises, even as you try to determine if it’s feasible or not to proceed with the deal. But you shouldn’t be penny-wise and pound-foolish. There are areas you must target and costly services you must use. That’s just part of the cost of any deal.
Company finances are a good place to start. It’s costly, but hiring an experienced accounting or consulting firm is essential. You are looking for the true financial picture of the company. You need to know whether the company is growing or shrinking, its profitability and cash flow, its capital needs, its customer concentration, and its relationship with its suppliers.
To get this information, a financial audit may be necessary, as well as obtaining a quality of earnings report. Beyond looking at the balance sheet, a quality of earnings report provides a true financial picture by looking at the financials, books and records of a company, including its EBITDA, earning power, cash flow, financial systems and its accounting principles and policies.
You should also conduct operational due diligence, looking at the company’s main operations to try and determine whether its current facilities and capital expenditures are in line with its present and future operations and that everything is in good condition. You might also want to conduct some commercial due diligence to review the market position of the company’s products or services. If you’re concerned about the company’s exposure to reputational issues, you may want to conduct IDD, an integrity due diligence. And of course, legal and regulatory due diligence is required to be performed by lawyers.
There’s a due-diligence provider for almost every aspect of a company, from its IT to its IP, but before you begin any of them, you’ll want to research the company’s leaders. You might be surprised what a simple Google search can yield. Compromising reputational matters, strained relationships with clients or suppliers, even fraudulent activity, can often be discovered with a few clicks of a mouse.
When you find something amiss, take a step back and review what can be fixed and what can’t. Sometimes a price adjustment works. Sometimes it’s best to walk away. But sometimes, you may find that the issues can be resolved or overcome, and the deal can move forward.
If the issue is something like sloppy bookkeeping, perhaps a good financial professional can clean it up. Maybe it’s just that the company isn’t running efficiently. In that case, you can hire a process improvement expert.
Even if it comes to pass that you do all your due diligence and everything checks out, remember that even with the best due diligence, you can’t always find fraud until it’s too late. For that reason, you might consider insurance in case everything isn’t on the up and up. Representation and warranty insurance may cover certain losses resulting from a violation of the representations and warranties that were made to you by the seller, whether intentional or not. It can be a useful tool to protect you from potential exposure should it arise.
But some problems can’t be fixed or are just too costly to fix. If that’s the case, you must walk away. And if you didn’t, and find yourself in a situation similar to HP’s, then it’s time to take a step back and see where your due diligence might have failed. Don’t look for another deal until you understand what you did wrong and how you missed the problem. A costly mistake can still have value if it teaches you how not to repeat it.