– The background check that could save your business.

This is the second in a three part series on mergers and acquisitions.

Mergers and Acquisition Committees and investigation sub teams

In the first article in this series, we discussed making the initial contact, entering into a deed of confidentiality in order to achieve the necessary exchange of confidential information, and the forming of an M&A Committee from both sides who have the authority to negotiate in good faith.

It is important then to start this phase with a brief consideration of the importance of this M&A Committee. The formulation of this Committee is instrumental to both the success of your proposed M&A and the next phase we will address in this article – Due Diligence. Just as the Committee is vital to the success of your proposed merger, so is your commitment to the teams you form to enact and investigate this merger. By failing to provide sufficient resources to enable the Committee / Due Diligence Teams to carry out their new duties, you run the risk of doubling or even tripling their workload, the unfortunate consequence of which may be the loss of those staff members and even the value they held in the eyes of the potential merging entity. Your staff already have full time jobs, and by burdening them with the additional strain of investigating and then, even implementing a potential merger, you can affect their existing work performance and morale. This can impact the existing business as well as the new merged entity.

As well as the need to adequately support your staff, you must also remember that the selection of these Committee / team members will be integral to the success of the M&A. It is not a job for just your Financial Manager; you should include representatives from various facets of your business beyond your accounts staff – you should include representatives from IT, marketing etc. The people involved in the actual implementation of the merger, should it progress beyond the due diligence stage, should be involved. For example, you would not have your Financial Manager decide the computer system the merged entity will use – mistakes like this can be a disaster and compromise months of painstaking deliberations which could have been avoided if the right person was asked the right question at the right time. This can and does happen.

Due Diligence
Due diligence is assessing your future investment and learning all you can about the company, the people and their culture with which you plan to merge. You need to examine every facet of the company and its employees’ expectations so as to avoid unpleasant surprises once you are married. It acts as a serious and in-depth background check on the company, its activities and true value.

Some major points to cover include:

  • Make sure you are happy with the company’s financials, ensure that employment contracts are in place to restrain potential deserters and protect your IP. You don’t want the true value of the firm acting like a runaway bride before merger day.
  • Are the firms and people a good cultural fit? Can you agree on a name and the new structure?
  • Take legal and accounting advice to formulate, in advance, what is the best new structure.
  • Make sure your accounting and computing systems are compatible, and make sure the company’s assets (including premises and all chattels) are all in order.
  • Understanding the “why” you are doing a merger is also important. You must be absolutely clear in this regard because issues will arise and you will need to determine whether those issues derail the true purpose of the merger.
  • If you are conducting your merger internationally, consult someone who has lived and worked in that country, and be aware of getting burnt by currency conversions under long term contracts. This is important beyond potential financial ramifications because local laws may affect your ability to be profitable, or the culture difference is too sizeable to get across.
  • Double check their insurance, debts, contingent liabilities and legal structures, and any latent risks.
  • Does the company have any professional indemnity claims in progress, and do you have client conflicts of interest? If conflicts impact major clients, ask them how they feel about the conflict; and if acting for both would mean the merged entity would lose out, re-examine the point of merging. How does it impact the “why”?

The appointment of a lawyer to check out any legal aspects and to assist in preparing a Heads of Agreement and the final M&A agreements is essential. An important partner in any M&A Committee is an experienced accountant. Often an accountant will analyse the financial mechanics of a merger in an analytical way. Gross fees do not in any way accurately reflect profitability. Sometimes professional practices, having been neglected for a long time, are forced to seek a merger as a means of avoiding going out of business. Some practices simply leave it too late. They have forgotten what “Business Development” means and how it is done. They are spiralling down.

The importance of goodwill
When paying for goodwill, you are paying for the reputation, maintainable earnings and a skill set of the individuals in the firm you are merging with or acquiring. Are the maintainable earnings reflected in profitability? If tied up with one or two individuals who are the “rainmakers”, are they close to retirement? Are there good employment contracts in place to stop any stars from waltzing out the door with clients? After the restraint period, ask yourself “Can we realise on what we have bought?”

If you are intent on paying for goodwill, there are different models you can use. The “earn it out” model records the actual earnings so that if the profit drops, so does the amount payable for goodwill. This may require maintaining different cost centres. The amount paid for goodwill (if small) may not justify this. Will it work contrary to integration and a “them” and “us” mentality? Using a correct goodwill multiplier (usually 2 to 3.5 times maintainable earnings), and a correct goodwill model and measured over what profit period (usually 3 years), are important considerations. Goodwill calls for the effective long-term transfer of the business from the seller to the buyer. If this cannot be achieved, there is zero goodwill.

Be prepared to walk away
You must be prepared to walk away from deals that are too risky, or diverge from the “why” behind the merge. Do not let egos affect outcomes. It is important not to over emphasise financial issues above strategic fit and cultural alignment. Putting strong due diligence into the “people” is just as important as any financial consideration. If your cultures are not compatible, time, energy and valuable resources are wasted.

To merge or not to merge? 
The importance of a thorough, exhaustive due diligence process is one of the most vital considerations of any merger opportunity. Without careful and considered examination of every facet of both businesses and a willingness to walk away, your M&A will not make you one stronger entity – it may be the unmaking of both. Staff your Merging Committee / Investigative Teams with capable people that represent the different skill sets that exist in your current business and that you hope would continue into the merged entity. Give them the tools to survive the merging process with their employment and sanity intact. Recognise the inherent risks and rewards in paying for goodwill. When you combine all of these together, you’ll have a solid foundation upon which to make the final decision – to merge or not to merge?

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This information is intended to provide a general summary only and should not be relied on as a substitute for legal advice.

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