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Working Toward A Successful M&A Deal

5/1/18 – Emir Hodzic

Without solid due diligence, an M&A deal can be fraught with disaster

A merger or an acquisition can be a long — and delicate — process, and there’s plenty that can go wrong before it’s over. To better the chances that your M&A will be a success, up-front and persistent due diligence work is a must.   

How strong are the financials?

The first thing that comes to mind when someone says “due diligence” is finances. You must know how a company has previously performed financially, as well as its current assets and liabilities, earnings and expenses, and other relevant information. Dissecting these numbers will give you a good idea on whether the valuation is going to hold up after the transaction closes. Financials reviewed or audited by an independent CPA firm will provide some comfort that the historical information is correct, however neither are designed to provide assurance that the company value is what it is portrayed to be.

Financial scrutiny should go beyond the usual and focus on the quality of the company’s earnings. If a target company recently reduced spending in areas such as research and development or advertising, ask why. Sometimes such reductions are merely efforts to improve perceived value.

Manufacturers in particular pose greater challenges in due diligence as specific industry knowledge is crucial. Poor inventory tracking and outdated costing methods are telltale signs of a business in which the financials are suspect. Often, companies will present their financials to potential investors with a number of normalized EBTIDA adjustments, or “one time add-backs”, and while common those adjustments should be thoroughly vetted to ensure not only their validity but also their nonrecurring nature.

Hidden liabilities can be another risk. You’ll want to know about potential exposure to environmental dangers, unpaid tax liabilities, possible legal claims from disgruntled employees or unhappy customers and vendors, and any other hidden minefields. Such liabilities can derail a promising transaction or significantly affect the purchase price.

Do employees understand their roles?

The success of a merger or acquisition rests heavily on employees’ shoulders, and you’ll need to communicate their future roles early and often. This is particularly important if certain executives or managers are essential to continued operations.

Don’t risk losing key employees through perceived indifference. Open and maintain lines of communication from the due diligence process to postintegration operations.

Have you overlooked any details?

Financial due diligence is critical, but it isn’t enough by itself. Other areas of a manufacturing company merit scrutiny before you begin the merger or acquisition process.

First, ask whether the plan makes sense. What do you hope to accomplish with this move, and will your potential partnership help you reach that goal? If it won’t, there’s no need to proceed.

You’ll also need to look beyond the obvious. For example, don’t rely on your gut instinct to tell you if the manufacturer’s customers are poised to shift their supply base. You need to study a potential merger partner’s customer base early to learn why customers do business with the company and whether changes are in the offing. Expect to meet with the major customers and make them as comfortable in the future of the business as you are as an investor in it.

Next, examine how productivity and profitability will improve after the transaction. Does the target company use lean manufacturing processes? How efficient is its work flow? Does it generate significant scrap material? What are its inventory levels? In other words, are there areas that you’ll be able to improve fairly easily?

Unwelcome answers to these and other operational efficiency questions may not be deal-breakers, but you’ll need them to conduct a realistic assessment. And don’t forget to consider the costs you’ll incur in implementing needed improvements. Understanding working capital needs should be one of the focal points of due diligence. Manufacturers often take significant customer deposits on orders which should be considered when examining accounts receivable and customer liabilities.

Is the technology compatible?

In today’s high tech manufacturing environment, you can’t afford to overlook information and manufacturing technology. Integrating two IT systems can be costly, frustrating and slow. Learn in advance whether your system is compatible with the other company’s and, if not, determine how much a solution will cost. If you’ll need a more specialized technician to keep a certain machining system running, for example, you want to know that in advance.

Have you performed an on-site inspection?

When you’re in the middle of performing due diligence, it may be tempting to stay in your office, solely relying on videoconferences and e-mail. Modern technology can make due diligence much more efficient, but it won’t tell you the full story on how a company operates — even with video.

For some assessments an on-site visit will be necessary. Walk through the target company’s plant and keep an eye on operations during your visit. Look for signs of stale inventory, workers missing required safety gear, and other signals that quality and efficiency may be lacking. If permitted, talk to plant supervisors and shop employees to get a sense of whether they’re committed to doing a good job — or just their job.

When you’re through, you’ll have a better idea of what improvements may be needed and what cost-saving opportunities are available. You may also come away with a sense of whether employees will welcome the change in ownership or resist it.

Aim for success

A merger or acquisition can be a part of an effective growth strategy for some manufacturers — when done correctly. Performing due diligence upfront can be the difference between success or disaster and most importantly despite how committed to getting the deal done you become, do not ignore the results of your due diligence.  Walking away from a bad deal is far less costly than making one.