Other than assessing the financial motivations for an acquisition, the due-diligence process undertaken by the buyer may be the most critical pre-closing process to the long-term health of the deal. A thorough exploration of the assets and liabilities of the acquisition target will inform the offer price, the terms of the deal, and any warranties or indemnities that will apply. A thorough and intelligent diligence process will detect those variables that determine the course of the rest of the process.
A repeatable process and core set of lessons learned from prior transactions is an important foundation for the process. If you or your client have been burned in prior deals, you should contract a thorough and objective after-action report to tease out what could have been done to prevent the problem or at least shift the risk back to the other party. Those lessons should then be incorporated in the next transaction and refined.
A set of templates or forms will reduce the chance that basic, obvious concerns will be missed but won’t do much to really illustrate the risks involved in the new transaction. This is no different from legal forms that we all use in our daily professional lives; they provide a helpful starting point but solely relying on them does not accomplish the objective. It’s the difference between rote knowledge and critical thinking. Simply stacking up isolated bits of information gives very little insight into the attractiveness, or lack thereof, of the target.
Contracts provide a ready example. The basic form might provide for an inventory of each of the target’s active engagements including a performance term and total estimated value, as well as highlighting certain terms of interest such as assignment, liquidated damages, limitation of liability, indemnity, and termination. These are all critical elements of the contracts that have an impact on the value of the business but they need a knowledgeable mind to tease out other facets. For example, knowing the termination rights incorporated into each customer’s contract provides a framework but it needs context to be truly useful. The next level of inquiry might include considerations such as:
- What are the realistic chances of the customer terminating?
- Are there other well-positioned competitors?
- Is there any associated intellectual property that might reduce the chances of termination?
- If termination occurs, what are the associated costs?
- Is there other work with the same customer or an affiliate that might be affected or used as leverage to influence the decision?
- What future opportunities may be impacted because of any changes to the current contract?
These are just a few additional impacts that should be involved in evaluating just that one clause of a single contract. The basic facts pulled into the summary table enable you to answer these questions, which handicap the monetary value of the contracts. A multimillion dollar contract early in its period of performance may appear highly enticing, but if it contains a liberal termination clause and the customer has an unstable budget and no appetite for follow-on work, the value begins to diminish quickly.
Diligence teams are always made up of a diverse group of subject-matter experts. My focus is typically on contracts, while a colleague focuses on insurance, another on litigation, and so on. None of us is well suited to address all the minutiae of the other subject areas, but none of the subject areas are especially meaningful without the others. A successful diligence effort requires the team members to not only have deep subject-matter expertise to understand the facts and nuances of their topic, but also a gloss of the other areas and the ability to know when to discuss it with another subject-matter expert. To address the six additional termination-related factors above, I either need to know a bit about business development and various finance disciplines, or better yet be smart and cooperative enough to flag them for others who know more than a bit.
If your diligence process simply focuses on identifying individual facts and doesn’t consider the places the various disciplines interact, it is destined to create problems in the future. A poorly executed diligence process can lead to a wildly off-base price, and the best-case outcome then may be a busted deal.
Taylor Brown is assistant general counsel with PAE Government Services Inc.