It is easy to dismiss the need for financial due diligence when contemplating a business purchase. Principals often feel that, having spent months getting close to their target, they best understand all the risks they will take on if and when the transaction is completed. They are quite right – nobody involved will have spent quite the same amount of time considering the merits of the transaction than the potential acquirers. They understand their industry and their business inside out and will have spent months, if not years, talking to their opposite numbers at a target.
Even so, a recent case that I was involved in reminded me of the power of financial due diligence. It concerned a potential merger of two service businesses. Discussions between the principals on both sides had gone on for more than six months, and were amicable. Heads of Agreement had been signed. Various third party lenders had indicated their consent to the merger proceeding. All seemed well and the transparency of the discussions between the two businesses was such that questions were asked about the need for, let alone the depth of, financial due diligence. After considerable discussion about the scope of the work, agreement was eventually reached on the financial due diligence that would be undertaken. Yes, it was to be limited and we helped guide the business principals on the risk areas based on a review of historical financial statements and current year management accounts, thereby keeping to the limited scope that had been agreed. The expectation was it would confirm what had already been disclosed during negotiations and nothing more.
So it was with some shock that, after only one week’s work on the documentation, we reported back some serious issues to our clients. With hindsight, those issues were not out of the ordinary, but they were a surprise to the business principals who thought there was nothing more to learn after months of face-to-face discussions. In summary, the points of interest from the due diligence were as follows:
• Adjustments to the current year management accounts which turned a small profit into a significant (six figure) loss. The prospective merger partner had made a significant six figure overprovision for accrued income compared with non-financial records it maintained.
• A further six figure impact from aligning the target’s accounting policies to the more conservative policies followed by our client. Its less conservative accounting policy meant a six figure sum for income had been recognised in the current year which our clients under their policy would have either deferred to a later period or spread over the contract period. Another six figure amount was recognised that our clients would have taken later and matched to end-of-contract expenses.
• There was a VAT over-accrual, but more significantly the target was struggling with a PAYE payment plan agreed with HM Revenue & Customs in the previous year. Payments in both 2009/10 and 2010/11 had been missed due to cash flow problems.
• Certain costs, incurred prior to the management accounts period end, had not been accrued for, leading to a five figure adjustment to results.
These were new items identified from financial due diligence work. When combined with issues that were already well understood from prior negotiations (i.e. a six figure directors’ loan due for repayment and the potential claw back of income under certain contracts), the clients decided they were unwilling to proceed with the transaction. Whilst they were willing to take on a certain amount of extra risk in the merger, they had not fully appreciated some of the difficulties faced by the target.
In the end the old adage “cash is king” was the guiding principle which meant the deal was called off. The target already had significant third party loans due for repayment in the short to medium term (i.e. the next three years) and learning that post merger there were likely to be significant cash calls to cover further unpaid bills (e.g. the missed PAYE payments) was too much to accept.
Of course, nobody involved in such a transaction sets out to see it fail – quite the reverse. So although there were some further discussions to see if an alternative way forward could be found (e.g. getting an agreement in place where one business would manage the other’s contracts in return for a fee), unfortunately no agreement could be reached. The principals of both merger partners parted amicably, but it was a ringing endorsement from our clients when they said: “Now we know why you do due diligence”. So never underestimate the importance of due diligence even when it appears that everything that could be disclosed in negotiations has been.