Litigation Learnings | The importance of a proper due diligence in a merger or acquisition

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Litigation Learnings Series

Practical tips on how to avoid
being caught up in litigation

By Paul Vincent

Paul Vincent - Forensic Services

Paul Vincent has been working in the litigation field for over 30 years and during that time has been involved in hundreds of very costly disputes, many of which could have been avoided.  This series of short articles draws on Paul’s litigation experience and provides practical tips on how to avoid being caught up in litigation.  Each topic will be supported by an actual case study that will demonstrate the importance of being “Litigation Smart.”

The importance of a proper due diligence in a merger or acquisition

If you are contemplating a merger or an acquisition, hopefully you will be conducting some sort of due diligence for the transaction.  A proper due diligence goes beyond getting copies of financial documents from the target entity and “having your accountant look over them.”  These are the cases that our litigation division see on a regular basis.

If you plan to spend a good deal of money on the transaction, why then is it not essential that you make sure you get at least what you bargained for?  If you get more, then that’s good management or good luck.  If you get less than you bargained for, then in 90% of the cases, it’s your fault for not undertaking a proper due diligence.  The other 10% are because of deliberate misrepresentation or fraud.

What to consider

All due diligence engagements involve the review, analysis and ultimately a decision based upon information.  Therefore, you should start by asking yourself 3 questions:

  • Where did that information come from?
  • Is the information accurate?
  • Is the information complete?

In no particular order, here are some of the things you should consider putting on your checklist to answer the questions properly and to ensure you don’t end up with something different to what you bargained for.

  • Financial Analysis
  • Customer/Client Analysis
  • Synergistic benefits
  • Critical contracts or agreements
  • Human resource analysis
  • Key person identification
  • Skeletons in the closet
  • Tax Compliance
  • ASIC compliance
  • Technology issues
  • Intellectual property
  • Occupancy analysis
  • Environmental issues
  • Related Party transactions
  • Competitor analysis
  • Key Supplier analysis
  • Past/current/future litigation
  • Insurance issues

Under each of these headings is a long list of activities that you ought to undertake.  For example, under the heading Financial Analysis, the following issues need to be considered:

  • What does the last three years financial records tell you about the performance and financial position of the business?
  • Who has prepared the financial records you are reviewing?
  • Are the financial statements audited?
  • If there are projections, are they based upon sound assumptions?
  • What is the business’ working capital requirement?
  • What are the capital expenditure requirements, quantum and timing?
  • What is the aging of accounts receivables/payables tell you about the business?
  • Are there any items in the financial statements that need adjustment which because of their size or nature, are not likely to continue after the transaction?
  • What is the business’ reliance on debt/equity and what might be the future requirement?

As you can see, your due diligence should extend way beyond the analysis of historical financial information and future cash flow analysis.  Money invested in the due diligence process may be the difference between a great decision or a tragedy.

Case Study

Here is a recent tragedy:

A purchaser of a business relied upon “an extract of financial results” presented to it by a business broker. He asked his own accountant to “have a quick look at the numbers” to see if the asking price was reasonable.  He gave his accountant a budget of $2,000 and two days to do the job.   The “extract of financial results” had some significant flaws which even a cursory investigation would have discovered:

  • Sales figures included GST, thereby overstating revenue and profit;
  • Wages excluded owners and their family’s wages which were actually “real” and needed in the business to derive profits. The “extract of financial results” stated the results were before owner’s remuneration, yet the purchaser made no enquiry of the significance of this cost, nor that they included two other family members;
  • The lease had only 2 years to run and there was no guarantee of any renewal.

The purchaser paid $450,000 for a business that essentially made very little profit and spent over $150,000 in legal fees and expert costs to recover the damages it suffered.  Delays in the litigation allowed the defendant to divest itself of assets and the case was abandoned as the purchaser ran out of funds to continue and any victory would have not resulted in any recovery.

Learning

The lesson to take away is that money spent up front will assist you in making the right decision.  It could help you negotiate a better deal and provide you with a better understanding of the key drivers of the target business.

Want to know more?

If you want to know more about the importance of a proper due diligence in a merger or acquisition, please contact Paul Vincent our Forensic Services Director for assistance.

An Important Message

While every effort has been made to provide valuable, useful information in this publication, this firm and any related suppliers or associated companies accept no responsibility or any form of liability from reliance upon or use of its contents.  Any suggestions should be considered carefully within your own particular circumstances, as they are intended as general information only.

 

 

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