Due Diligence in Mergers and Acquisitions

I. Introduction

In order to ensure the success of a merger, both companies need to carry out due diligence in order to take an informed decision. It provides the companies a chance to gain access the information and analyze it. It allows the companies to evaluate if their expectations are being met. This protects the companies from protentional window dressing that occurs and can jeopardize the merger. It also gives them the chance to identify any problems that might occur from the merger and allows them to avoid the merger. The Due diligence is carried out by a third-party as there is no bias.

It also helps the companies avoid future liabilities due to unchecked problems in the merger of the companies. This can include the financial aspects of the merger as this can lead to an ongoing financial liability on both the companies. This can occur from window dressing that can be done by either of the companies and this can mislead about their financial state and paint a picture that fraudulently influences a merger to occur. This can be in terms of cooking the books and making the company look more profitable on paper than it is.

It also assesses other aspects such as the stability of the revenue stream as it is possible for a company to be profitable and not have a sustainable revenue stream. Due diligence helps highlight existing problems that stops the merger from taking place as well as future problems that the amalgamation can cause. This includes analyzing regulatory problems that exist in the company as well as the industry of operation. It also analyses the liabilities of the merged entity as this foresight can help both companies from taking a rash decision. It analyses the risk components existent in the company as well as in the industry of operation.

It analyses at the sustainability of the customer base as that is required in order to attain long term sustainability. Due diligence also highlights the internal functioning of the company and hence explores the compatibility of the companies. It analyses the value generating assets of the company so more focus can be placed on them, and they can be further developed in order to make the company more profitable.

II. Types of due diligence in m&a

1. Financial Due Diligence

The books of accounts are reviewed, and all the financial transactions carried out by both companies are audited. The statements of several years are reviewed as a single year can be misleading and hence a pattern can be discerned by way of audit. The bank statements are also analyzed. The assets and liabilities are investigated in order to get the complete picture of the financial health of the company. It analyses the area the company would operate in as well as the customer base as well as the segments and important details with regards to that. It also studies the products and services offered by the company. It also provides details about the vendors and partners involved with the company.

The Memorandum of Association is also submitted and is prepared during the inception of the company.² It defines the relationship the company has with vendors and shareholders. It also studies the objectives of the companies. It dictates the external transactions of the companies in order to check the compatibility of the companies. It also contains the authorized capital of the firm. It contains the name clause that states the name of the company. It must also contain the address to the registered office of the company.

The Articles of Association contain the regulations of the companies and lay down the rules to be abided by. This is essential in terms of analyzing the compatibilities of both the companies. It can be altered by simple majority and has a binding force on the members of the company with reference to all activities of the companies.³ The companies must also submit revenue reports every month in order to establish a pattern. It should contain the cost incurred per employee in terms of salary, compensation, incentives, stock options provided to employees, wages, and details of the contracts with the workers and employees. It should have the rent incurred by the company in all the spaces they rent or lease.

It should contain the technology costs incurred by the companies and includes the equipment, servers maintained by the company and apps, website or domain development costs. It should have details of the bank accounts and any outstanding loans of both companies. The details of all debtors and creditors should be mentioned. The companies should mention all investments they entered as well as other details such as amount invested and duration of investment.

2. Cultural Due Diligence

This starts with companies underlining their own cultural competencies and practices as well as strengths and weaknesses in order to assess if the other company can merge well and create value without disrupting the functioning with irreconcilable problems. The culture of the organizations permeates all spheres of decision making and lacking compatibility in this area can result in problems in the daily functioning of the merged entity. It requires analyzing the values of an organization and understanding if they are compatible. This encompasses all rituals, practices, activities and appraisal as different organizations look at different aspects in order to promote someone. They also have different criteria for what behaviors are rewarded and what is unacceptable so a total analysis of the compatibility of the companies is necessary.

3. Strategic Due Diligence

The strategic due diligence investigates whether the companies are a good fit for each other and if a merger is realistic. This form of due diligence examines if the merger is commercially viable. This analyses if the merger has the propensity to make profits for the company. This is important as the assumed synergy on paper can have different practical applications. It assesses the strategic reason for the merger and the supposed benefits from the deal. Strategic due diligence is also traitored to the deal and the two companies as no two deals are the same and the key factors differ. This is because a due diligence procedure that doesn’t assess the real and varied difference of the two companies, the deal is bound to fail. Companies in the same industry cannot be gauged by the same methods.

This involves identifying key areas of the companies that have the potential to create value in the merger as well as the areas that can cause a challenge to the merging of the entities. It also gauges if the expectations set with reference to the merger and supposed target value are practically achievable. This is necessary as one of the biggest factors that lead to the failure of a merger is paying an unrealistically high price for the target company. Another important factor is the choice of the target company as it becomes apparent only after the acquisition⁴.

4. Intellectual Property Due Diligence

This process includes defining, analyzing, and examining the due diligence. This analysis must reveal the value attained by the intangible assets of the company such as, Patents, Copyrights and Trademarks. They also study any IP related issues that exist and what the strategic to resolving them is. It also reveals if the IP assets of the company are at the heart of the transaction or a bonus. This allows the company to shape their future plans for the companies as they can capitalize on the benefits of the IP. Companies must also assess the liabilities of owning the IP and analyze all the risk incurred by them. It examines if the company legally owns the IP rights as stated. It studies the scope and extent of coverage of the patents as well as their enforceability.

5. Legal due diligence

This allows all ongoing litigations that can jeopardies the merger to be known and protects the merging entities. It also assesses what aspects of the business could lead to future litigations and allows them to plan for it. It requires both companies to provide all ongoing contracts with vendors, service providers, part-time contractors, consultants, employees and all other individuals that are associated with the company by way of contract. It allows them to assess what the vulnerabilities of the company are in terms of probable causes of litigations. Companies have to share documents listing their association with shareholders as well as creditors and debtors in order to assess the risk of litigation. The legal due diligence also looks at the liabilities of the companies and what can be improved going forward.

III. Case study

Mergers rely heavily on the judgment made by companies on their profitability on the basis of due diligence. It can make or break the deal and

1. Hewlett-Packard’s (HP) acquisition of Autonomy

HP decided to takeover Autonomy with the goal of growth and creating value. HP had expertise with hardware and Autonomy had capability with software. This takeover was an attempt to harness the synergy of both the companies capabilities and channel it into a complete service by entering a new market with an established company. The price expended in this takeover was $ 11.1 Billion USD. After the completion of the merger it was revealed the Autonomy cooked the books and the deal led to a big financial liability on HP and the cause for the failure of the merger. the specific fraud carried out by Autonomy was window-dressing of the Income Statements, Cashflow statements and Balance Sheet. The loss incurred by HP was $ 5 Billion USD that could have been avoided with better due diligence as it lasted only 6 hours. The shareholders of HP sued them as it was believed that due diligence would have helped in identifying the problems with the merger.

2. Quaker Oats and Snapple

Quaker acquired Snapple for a purchase price of $ 1.7 Billion USD despite warnings bells from wall street that the price was too steep. This resulted in Quaker selling Snapple within 27 months in order to reduce the liability as the resulting loss from the merger was $ 1.4 Billion USD. Quaker lost $2 Million USD for each day they owned Snapple. The reason for this failure was Intellectual Property Due diligence mistakes as well as failure to assess the revenue channels for Snapple and a failure to gauge the market analysis that revealed the companies were not the right fit.

3. Matsushita’s Acquisition of MCA

Matsushita, a Japanese company acquired MCA for $ 6.5 Billion USD and it was considered a strategic move. The issues were caused by cultural facets of the operation such as the heavily bureaucratic style of Matsushita. They would also turn down persistent fund requests from MCA. There were gaps in communication due to the executives of Matsushita not understanding English. This shows a lack of cultural due diligence as companies often carry out all types of due diligence and leave out the cultural aspect that causes insurmountable challenges. The loss incurred by Matsushita on account of this acquisition was 164.2 Billion Yen.

IV. Conclusion

Due diligence is the investigation undertaken by both companies in order to ensure the financial health of the companies. This is done by vetting the various aspects of the operation of the companies. This is also down in order to confirm the facts stated by the companies as it is possible that fraud may have been used in order to induce a merger. Due diligence assesses the obligations, contracts, liabilities, contractual obligations, ongoing and protentional litigation and profitability of the companies. The profitability must be gauged over a period of time as a single year can be deceptive and inaccurately show the financial status of the company.

Due diligence also analyses if the value the companies wish to gauge its attainability. This helps the companies save a significant amount of time and money as a failed merger can cause adverse effects. It also protects the rights of the shareholders as these decisions can have a major impact on them and they aren’t involved in the deliberation process. Due diligence is required to ensure the compliance with the required regulations. The companies must also disclose any facts that might impact the deal.

It is important for companies to allocate enough time for this process as a wrong decision can jeopardises the future of the companies. Lack of due diligence inevitably becomes the main cause of the failure of mergers and often the companies experience this only after the completion of the merger at which point the financial damage done to the company cannot be undone. It is best for the company to opt for a third party team as this ensures fairness and transparency in the process.

*****