Why Do Acquisitions Fail? Part 5 – Due Diligence & Legal Agreements

In the penultimate post of this series, we focus on Phase 5 of our Acquisition Process – Due Diligence & Legal Agreements. At the end of this phase, you will own the target company, so it’s crucial that you consider the objectives of this final phase. Are you focusing on the historical past of the target or are you fixated on life under your ownership?

The mistakes we have observed over the last 20 years almost all relate to missed opportunities. So many opportunities to audit the signals have been missed by many acquirers by the time they reach this phase, and so they enter due diligence on shaky ground. Here are the biggest mistakes we’ve noticed during this final stage (hint: some of them started way before this phase).

Common Mistakes

1. 1. 1. Post-acquisition models are built on poor analysis leading to the omission of key assumptions to be validated during due diligence. Examples of assumptions not validated/mistakes include:
         • Assets are in great shape with limited capex required.
         • All key customers will come across with the deal.
         • ERP systems are totally compatible allowing financial integration on day 1.
         • Target’s products will be easily sold through the acquirer’s vast distribution network.
         • Sales commission structures on both sides are similar.
         • Earn-out is both practical and understood.
         • Key executives’ reward structure has significant owner benefits that will discontinue post-acquisition.
         • IP is owned by the company (it’s not, original founder no longer with the business owns it)
      2. The acquirer’s operations team has not had an opportunity to kick the tires, including understanding the sales process, assessing the technology, reviewing service contracts, assessing the product roadmap. Consequently, the due diligence list is way too long given the tight deadlines.
      3. Credibility of financial forecasting has not been tested and has been left to the financial due diligence team. Unfortunately, the valuation and deal structure have been agreed, which makes changes at this stage contentious if the forecasts are found to be unreliable.
      4. The deal leader fails to brief the due diligence team on key discoveries made so far. The acquisition process, if done correctly is a continuous fact gathering experience. People, processes, operational data, financial facts and many more key discoveries are completed running up to formal due diligence. Yet the handoff to the commercial and legal due diligence teams is often bungled leading to an incomplete picture and a due diligence plan focused on the wrong issues.
      5. The legal team are invited to join the process and the acquirer’s legal counsel draft the first draft of the Purchase and Sale Agreement (PSA). In our opinion legal teams should join the process much earlier. By leaving them out of the earlier stages of the process, the drafting of the contract becomes inefficient. Many commercial issues already uncovered in Phases 3 and 4 should be covered by the PSA but the legal team is unaware.
      6. In these final stages of the deal, many acquirers behave as if they own the business. The volume of requests increases, deadlines become tighter, and the seller’s limited bandwidth and workload are ignored.

   These types of mistakes don’t necessarily stop deals, but they undermine the long-term success post-acquisition.

   Better Way

   1. 1. 1. 1. We believe due diligence is an opportunity to validate your post-acquisition integration plan. There are standard historical facts, figures, and contracts that you will review of course. However, we demand that acquirers use the limited time in due diligence to validate life under your ownership (as well as the standard checklist of key facts). Here are some examples of items on our post-acquisition validation list;
               • Ability to sell the target’s products to our customers.
               • Ability to sell our products to the target’s customers.
               • Assumptions around the top ten customers.
               • Confirmation of NPS history and outer loop actions.
               • Quality of the target’s sales process.
               • Ease of integration of ERP systems.
               • Overlap of the marketing technology stack
               • Quality of product roadmap.
               • Physical assessment of plant & machinery (depends on the business).
               • Close examination of sales commissions and ease of harmonizing them.
               • The motivation of the leadership team to stay post-acquisition.
               • The target management team’s belief in the strategic plan.
               • Expectations of the target’s management team regarding accessing resources from the acquirer.
               • If relevant, the understanding of the earn-out formula and strategies to achieve success.
               • Possible flight risk of key staff.
            2. “Acquisitions are for operators”. This is our mantra, which is backed up by our decades of experience and by all significant research done on successful acquirers. The acquirer’s acquisition team must contain operational experience beyond the corporate development team (we see evidence that PE-backed portfolio companies do this far more often than their public company brethren). At the appropriate stage, it is vital that operational leaders who really understand how to make money from your sector are allowed to stress test the target.
            3. Integration expertise should be shared with the deal team before the price and deal structure are agreed. One research paper cited Dow Chemical’s M&A Expertise Center which “swam upstream” to incorporate its knowledge earlier in the process by supporting the deal negotiation teams. By explaining implementation issues to deal negotiators, an opportunity is created to influence the strategy, valuation, and deal structure before it’s too late.
            4. Once the LOI is signed we recommend a comprehensive briefing is conducted by the acquisition team to the due diligence teams and legal counsel. This must include the commercial rationale for the deal, the red flags discovered to date, the key elements of the post-acquisition plan, and the commercial risks required to be covered by the legal agreements including warranties and indemnities.
            5. Give careful consideration to how you communicate the conclusions of due diligence. There are really only three conclusions; the deal is not feasible, the deal can proceed but material changes to the deal are required, the deal can proceed with no material changes. We recommend the acquirer meets with the principal deal leader from the seller side prior to due diligence to reiterate all key assumptions supporting the deal. This way if a key assumption is invalidated during due diligence, a healthy conversation can be had with the other side. If there is a problem, whilst these are not easy conversations, at least you are being consistent and professional rather than being seen as unreasonable and even deceitful.

            In summary, due diligence is an opportunity to validate the strategic alignment and post-acquisition plan of your deal. The PSA should attempt to protect the acquirer from the risks inherent in the deal and where possible wrap warranties around key assumptions being relied upon.

            TPP is buy-side investment banking reimagined. We seamlessly become an extension of your team and integrate at all levels to add deep mergers & acquisitions into your business.

            Ian@TPPBoston to arrange a conversation.