Due Diligence in Reverse

Companies in the midst of being acquired expect the potential acquirer to perform a thorough due diligence review. But what level of due diligence on the acquirer, or “reverse due diligence,” should they demand?

There are several aspects this question.

Cash as consideration

First, for the investors / shareholders, does the health of the acquirer affect the consideration received? In the case of an all-cash deal, it’s pretty clear that it doesn’t matter. As long as the acquirer has access to the cash and provides adequate comfort that the transaction will close, not much further is necessary or can be demanded. But if the consideration is the stock of the acquirer, some level of investigation of the acquirer is called for.

Stock as consideration, large public company as acquirer

If the acquirer is a large public company, a request for reverse due diligence may be met with a curt, “Please refer to our website and to www.sec.gov for everything you need to know.” In fact, the stock of large or heavily traded public company can be treated much like cash, as it has a more concrete value and can be readily sold. Thus, the same public information available to institutional and individual investors should suffice.

Stock as consideration, smaller public company or private company acquirer

If the acquirer is a public company with a low trading volume or is a private company, the issue of reverse due diligence certainly comes into play. Investors in the target company expect to understand the value of the new combined company. However, the acquirer, feeling like they are the party that is “paying,” will expect the review to be limited. To me, a reasonable middle ground is for the acquirer to provide information consistent with what it would provide a similar size cash investor in the company.

Additional considerations for the executive team

For the executive team, there are additional concerns regarding the health, future, and vision of the acquiring company. For some of the team, they will have a moral expectation and financial incentive to stay with the combined company for a period of time, so they are betting personal opportunity cost over and above the risk incurred by the other shareholders. The team should understand and be comfortable with the future direction of the combined company, much as if they were interviewing for their future positions.

Overall, the issue of reverse due diligence is highly situational, ranging from cases when it is completely inappropriate to cases when it absolutely should occur. It’s important to identify which of the above instances is relevant in order to take a responsible yet reasonable position.

Should We Make That Strategic Investment?

As a large technology company, is investing in a smaller commercial partner a great opportunity strategically and financially, or is it a distraction and a waste of resources?

I’ve seen quite a bit of discussion on the subject of whether a small, growing technology company should take a strategic investment from a larger company in the same industry. However, I’ve seen much less that addresses the pros and cons from the standpoint of the potential strategic investor. For that matter, looking at the issue from their perspective should be informative for both sides.

Assume a scenario where the “strategic investor” is planning to enter into a commercial partnership with a “growing company” (as I’ll refer to each of them throughout). Frequently, the growing company is in need of funding, visibility, and credibility, all of which the strategic investor can provide. The subject may turn to whether it makes sense to pair an investment and deeper relationship with the commercial partnership.

In evaluating the pros and cons of such a transaction to the strategic investor, there are several factors that weigh on each side of the decision.

The benefits to the strategic investor are:

1. Realize some of the value it is helping to create

Financially, the investment allows the strategic investor to capture some of the value that it adds by directing business to the growing company and due to the “halo” effect the growing company receives by virtue of being associated with a more significant player.

2. Achieve a closer relationship due to an ownership interest

If the strategic investor is interested in developing a closer relationship with the growing company, an ownership position and board seat / board observer is an ideal way to accomplish this. This may be beneficial as a form of due diligence for a future acquisition, or it may be helpful from the standpoint of technology learnings and cooperation.

3. May provide an “inside track” for an acquisition in the future

While this type of investment is unlikely to provide a legal path to control or much in the way of preemptive rights, it can provide an easier path to an acquisition in the form of practical benefits. The strategic investor will have greater knowledge of the status of the growing company’s progress, and may become aware of other potential suitors at an earlier stage.

4. May act as a slight deterrent to competitors as partners or acquirers

While restrictions on partnerships or acquisitions by competitors may not be part of the legal agreement, there may be a practical benefit here as well. Competitors may assume that the growing company is firmly connected to the strategic investor and may therefore focus elsewhere. (Of course, this type of issue could be of concern to the growing company.)

The downsides to the strategic investor are:

1. High-risk and non-core investment

From a purely financial standpoint, venture-type investments are typically outside of the strategic investor’s core business, and small investments are unlikely to produce meaningful returns on an absolute basis.

2. Growing company can become a distraction

Access to a new partner is a two-way street, and it’s likely that the growing company will be interested in speaking to and working with various divisions within the strategic investor. While the exchange can be helpful for both sides, it can also become a drain on resources relative to the core mission of the strategic investor.

Taking all these factors into account, I believe that this type of strategic investment can be useful in select situations where it is important to establish a deeper relationship with a growing company, possibly in preparation for an acquisition in the future.

Four Important Things to Know Before You Sell Your Company

The idea of selling your company, receiving a huge payment, and then relaxing on a quiet beach sounds very attractive – what’s not to like? However, it’s important to know what to expect before making the decision to sell.

Here are a few of the basics to be prepared for when contemplating selling your company:

1. Be patient

Even with interested buyers, the process of getting to an acceptable price for both parties and getting the buyer comfortable enough to pull the trigger can take 3-6 months. Of course, the length of time to close a deal can vary widely. I was involved in SBC Communications’ acquisition of Pacific Telesis, which took only 1 month from the beginning of due diligence to announcement. On the other hand, I’m currently involved in a nine-party transaction which has been brewing for 8 months (and counting).

2. Get expert assistance

I’ll admit that this is what I do, so the statement is self-interested. However, I truly think that it is ill-advised to try to “go it alone” when the stakes are so high. It’s likely that you, others on the executive team, board members, and VCs have been exposed to M&A transactions, but there is much more involved in managing a successful deal. Get your advice from somebody who is truly an expert, even if that means calling on a friend or a contact on an informal basis.

A knowledgeable M&A attorney is also an essential member of the deal team (but is not likely to be able to fill the role described above). In addition, be prepared to engage tax and accounting specialists as needed.

3. Dedicate enough time

Even with an M&A expert to provide advice and manage the deal team, you (and other members of the executive team) should plan on dedicating enough of your own time, particularly if many of you will be staying on post-deal. In management meetings that are part of the due diligence process, potential buyers will want to hear directly from you. In addition to providing the detailed knowledge about the business and where it is going, there is no substitute for the enthusiasm of the team in charge.

4. Get organized

A potential acquirer wants to see that you have knowledge of and control over the business. Therefore, have all the relevant financial, accounting, legal, and operational information organized and ready to go.

Selling a company can be a grueling process, but with the right preparation, expectations, and support, you can make good decisions about if and when to start down that path.

Which Comes First, the M&A Strategy or the M&A Execution?

The obvious answer to this is that M&A strategy comes first, and M&A execution follows the strategy. I agree with this as the ideal and preferred method for determining acquisitions, but I’d argue that there is actually room for the reverse as well, with proper discipline.

Clearly, the textbook order of progression is:

1. Corporate strategy
2. M&A strategy
3. M&A screening and targeting
4. M&A execution

This methodology should be the foundation for setting and executing on a company’s M&A priorities.

However, a potential acquisition can be extremely helpful in sharpening M&A strategy, as it provides a current and live possibility to qualitatively and quantitatively analyze. So often, the exercise of setting strategy is performed too much in a vacuum, devoid of real-world issues, and allowed to progress indefinitely.

To be clear, I am NOT recommending that M&A activity drive strategy, but I am suggesting that M&A activity can and should help refine the strategy. As far as which comes first, the two are not mutually exclusive. Rather, it is an iterative process in which learnings from M&A execution feed back and inform the M&A strategy, so the process looks something like the diagram below.



There is a level of discipline required in doing this. M&A professionals should not have license to run off in all directions. They need to focus on the general areas set by the corporate strategy, but they should have the ability to perform a “quick screen” on companies outside of the stated target area.

Likewise, the corporate strategy should not dictate an M&A plan so set in stone that it does not have the flexibility to evaluate “out of the box” opportunities within the range of reason, or to spur a dialogue about new acquisition targets that can help refine a company’s M&A strategy.

In my experience, greater freedom in M&A execution, combined with using key learnings from actual and potential transactions, can enhance the standard serial process of strategy-execution and result in better deals.

Planning Ahead to be Acquired

In Mergers & Acquisitions, a logical corollary to the acquiring company asking itself “What am I buying?” is the selling company asking itself:

“What am I selling?”

A company should be run as an ongoing business, not with the express purpose of an exit. However, there are measures that can be taken to increase the odds of eventually being acquired.

One of those is to determine the companies most likely to be potential acquirers and what each of those companies would view as the seller’s most important attributes. In other words, think a step ahead to how the various potential acquirers would answer the “What am I buying?” question.

A list of possibilities, outlined previously, is:

· Product, service, or technology, or a platform that can support additional products
· Customer base / traffic that is attractive or significant
· Distribution channels or hard to duplicate partnerships
· Human resources, such as the management team, development team, or other technical expertise
· Intellectual property
· Brand or reputation
· Fixed assets or property
· Financial characteristics

Next, be sure that those key attributes of the company become or remain strengths. For example, assume it is likely that potential acquirers will focus on a particular service of the seller because it would provide a time-to-market advantage relative to the acquirer developing the service itself. In that case, one of the company’s priorities should be making sure that particular service continues to develop in a way that will be attractive to potential acquirers.

Again, focusing on the attributes most likely to provide an exit should be merely one priority among the many that a growing business juggles, but the strategy discussed above can make the difference in ultimately becoming a compelling acquisition target.

The Most Important Question in Mergers & Acquisitions

An acquisition is obviously a very involved process, involving strategic considerations and numerous qualitative and quantitative criteria. The importance of being thoughtful, thorough, analytical, and prepared cannot be overstated. However, it’s frequently helpful to take a step back during the acquisition process to ask:

“What am I buying?”

Of course, there’s no right answer, but there should be a clear one. There are a number of possibilities, such as:

· Product, service, or technology, or a platform that can support additional products
· Customer base / traffic that is attractive or significant
· Distribution channels or hard to duplicate partnerships
· Human resources, such as the management team, development team, or other technical expertise
· Intellectual property
· Brand or reputation
· Fixed assets or property
· Financial characteristics

I’m sure there are a number of other potential answers. The point is to not lose sight of the core reason for the transaction.

Knowing the answer to this key question makes it easier to confirm whether the transaction is really necessary, how scarce and valuable it is, and whether the same attributes are better achieved through a build or partner strategy. For example, if the customer base is the key asset, can the same thing be achieved within a reasonable amount of time by spending marketing funds?

In addition, the answer should influence areas of focus during due diligence, as well as key terms during negotiations. For example, if the management team is the key asset, they should be a focus of due diligence, and the ultimate deal needs to be set up so they are likely to stay.

Finally, the answer to “What am I buying?” should be the cornerstone in communicating a crisp rationale for the transaction to the board, investors, employees, vendors, customers, the financial community, and the media.

Although this advice may seem simple and obvious, it’s surprising to see how often it is overlooked in the frenzy of dealmaking.

Mergers & Acquisitions Due Diligence, Complete Series

For convenience, the full four-part series on “The Basics of Mergers & Acquisitions Due Diligence” is now available as a single reference document. It can be accessed here or from the bottom of the Baker Pacific home page.

Mergers & Acquisitions Due Diligence, Part 4

In advising companies that are acquisition candidates, two of the questions that I most frequently receive are:

1. What should I expect from the due diligence process?
and
2. How can I best protect my confidential information while still moving the process forward?

I already covered #1 (see Due Diligence, Part 1) and Parts A and B of #2 (see Due Diligence, Part 2 and Due Diligence, Part 3). I’ll finish with Part C of #2 in this post.

How can I best protect my confidential information while still moving the process forward?

As discussed previously, there are three actions that a company can take that will decrease the odds of wasting time and unnecessarily parting with sensitive information, while not overly encumbering the acquisition process:

A. Gauge the seriousness of the potential acquirer (see Due Diligence, Part 2)
B. Stage the flow of information (see Due Diligence, Part 3)
C. Be on the lookout for warning signs (covered below)

C. Be on the lookout for warning signs

Throughout the process, it’s key to continually evaluate the potential acquirer in a number of areas. Most important is overall trust. If they have been honest and straightforward in the negotiations, that’s a good sign for their integrity overall.

While the seriousness of the acquirer was previously discussed in #2A, it can be even better judged as the process continues. See if their actions are those of a serious acquirer: how big is the team, how much time are they spending, and are they spending cash to evaluate the transaction (e.g., investment bankers, attorneys, accountants).

An experienced acquirer should understand the staging of information previously described in #2B. If they are unreasonably frustrated at having to wait, that could be a red flag.

Does it feel like they’re just fishing for information that’s not critical to the deal but could be important to a competitor? The focus of the due diligence can vary depending on the acquirer, but everything should track back to understanding the business, assessing its value, and avoiding risk.

Which groups from the potential acquirer are involved? Typically, there is mostly corporate-level involvement early in the process, and more operational people and specialists later. Think about the groups at the potential acquirer that are the biggest competitive threat, and if there is a disproportionate number from those groups, make sure you understand everyone’s role as it relates to the M&A process.

There is obviously a lot more involved in running a productive due diligence process, but the topics in this post and the previous ones cover some of the important basics regarding expectations and protection.

Mergers & Acquisitions Due Diligence, Part 3

In advising companies that are acquisition candidates, two of the questions that I most frequently receive are:

1. What should I expect from the due diligence process?
and
2. How can I best protect my confidential information while still moving the process forward?

I already covered #1 (see Due Diligence, Part 1) and Part A of #2 (see Due Diligence, Part 2). I’ll cover the Part B of #2 in this post, finishing with Part C of #2 in two weeks.

How can I best protect my confidential information while still moving the process forward?

As discussed previously, there are three actions that a company can take that will decrease the odds of wasting time and unnecessarily parting with sensitive information, while not overly encumbering the acquisition process:

A. Gauge the seriousness of the potential acquirer (see Due Diligence, Part 2)
B. Stage the flow of information (covered below)
C. Be on the lookout for warning signs (to be covered in the next post)

B. Stage the flow of information

Staging the flow of confidential information based on the overall progress of the transaction is one of the best means of protection. Early in the discussions, less sensitive information is shared, and as the potential acquirer progresses and shows that it is serious, more sensitive information is shared. It forces the potential acquirer to “earn” the most sensitive information, and limits the number of parties that will see the most highly confidential documents.

While an NDA provides the legal protection, this method adds practical protection. Implementing this method involves staging due diligence into at least four phases of information sharing, although there’s not necessarily a defined break point between each phase.

(1) The first phase consists of the high-level, pre-NDA information, such as a “teaser document” and information that is already contained on the company website.

(2) Following an NDA is more detailed information on all aspects of the company (see Due Diligence, Part 1 for details). This information is typically heavier on current and historical information than on forward-looking projections. Quite a bit of confidential company information is disclosed in this stage, but very little that is competitively sensitive.

(3) The next phase involves the most sensitive company information, including projections, customer information, and any other requests from the acquirer deemed too sensitive to share earlier in the process. The process should be far along and the acquirer clearly serious before sharing these “state secrets.”

(4) Finally, the accounting and legal due diligence, is frequently at the end of the process. This phase is last more for reasons of cost and the larger number of people involved than for confidentiality reasons.

Mergers & Acquisitions Due Diligence, Part 2

In advising companies that are acquisition candidates, two of the questions that I most frequently receive are:

1. What should I expect from the due diligence process?
and
2. How can I best protect my confidential information while still moving the process forward?

I addressed #1 last time (see Due Diligence, Part 1) and will cover Part A of #2 in this post, with the remainder in the next two posts.

How can I best protect my confidential information while still moving the process forward?

Potential acquirers are typically trustworthy and sincere in their intent when conducting due diligence, with making an acquisition the goal rather than gathering competitive intelligence. However, some may enter the process with both goals, and a few may actually have bad intentions.

With that in mind, there are three actions that a company can take to decrease the odds of wasting time and unnecessarily parting with sensitive information, while not overly encumbering the acquisition process:

A. Gauge the seriousness of the potential acquirer (covered below)
B. Stage the flow of information (to be covered in the next post)
C. Be on the lookout for warning signs (to be covered in a future post)

A. Gauge the seriousness of the potential acquirer

In addition to the intentions of the potential acquirer, judging their seriousness at the beginning of the process and throughout can save a target company lots of time and frustration. In my experience, frequently a company would like to make an acquisition but simply is not in a position to do so.

There are number of easy ways to test for this, including the following.

Evaluate the company’s financial ability to make an acquisition. Do they have the cash to make a cash deal? Do they already carry a large debt burden, or do they have the ability to borrow to finance the deal? In the case of a public company, it is feasible to consummate a stock deal? The company should be able to provide a clear and realistic plan on how they would structure and finance the deal.

Evaluate the means of initial contact. Was it through a senior executive or board member, or through a person with less authority? If was through an intermediary, how credible is the intermediary, and is it formally representing the company?