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Nexia Ebner Stolz

Auditing

Pitfalls in corporate acquisitions

Anyone who spends a lot of money to acquire something would surely like to know whether what he’s buying is what he thinks it is. Who wants to buy a pig in a poke?

Every inves­tor who’s got his eye on a com­pany would like to know what’s going on behind the sce­nes, which is why he care­fully scans the com­pany’s busi­ness model, finan­cial sta­te­ments, tax situa­tion and con­tracts. The past and the future are both on trial, and thus so are the fore­casts for the com­pany’s deve­lop­ment. One pro­ven way of accom­p­lis­hing this is by a due dili­gence pro­cess. Due dili­gence inves­ti­ga­ti­ons shine lights in dark cor­ners, make sure that eve­r­yone has access to the same infor­ma­tion, and iden­tify and eva­luate risks in a sys­te­matic fashion. Pro­perly pre­pa­ring due dili­gence is half the battle – and that app­lies equally to purcha­sers and sel­lers. There are four types of due dili­gence: com­mer­cial, tax, legal and finan­cial.

Com­mer­cial due dili­gence

Com­mer­cial due dili­gence puts the stra­tegy and mar­ket posi­tion of a com­pany to the test. It deals with the spe­ci­fic cir­cum­stan­ces of the mar­ket and com­pe­ti­tion: What are the com­pany’s strengths and weak­nes­ses, how is its mar­ke­ting stra­tegy wor­king, what are the bar­ri­ers to mar­ket entry, which busi­ness pro­ces­ses are value dri­vers, which are criti­cal for suc­cess? And above all: are the tar­get growth rates and gross ear­nings expec­ta­ti­ons rea­listic?


Tax due dili­gence

Tax due dili­gence ana­ly­ses the com­pany’s tax situa­tion: have there been any essen­tial chan­ges in struc­ture? Are there hol­ding periods that need to be obser­ved? Are there any tax loss carry-for­wards that could be lost because of the plan­ned tran­sac­tion? It also pro­vi­des a basis for deci­ding how a pos­si­ble invest­ment can be opti­mi­zed for tax pur­po­ses.

Legal due dili­gence

Legal due dili­gence is about con­tracts and agree­ments that are important to the com­pany and ran­ges in scope from the eva­lua­tion of license and sup­ply agree­ments to the ana­ly­sis of lia­bi­lity and war­ranty risks. The main issues to be dealt with in the purchase agree­ment are also pre­pa­red during the due dili­gence phase.

Finan­cial due dili­gence

Finally, finan­cial due dili­gence deals with the com­pany’s figu­res. Begin­ning with a solid ana­ly­sis of its past that exa­mi­nes such his­to­ri­cal fea­tu­res as its ear­ning poten­tial, cash flow situa­tion, wor­king capi­tal deve­lop­ment, and adhe­rence to bud­get, finan­cial due dili­gence scru­ti­ni­zes the com­pany’s cur­rent deve­lop­ment along with its plans for the next three years. An expert opi­nion will be given on the plau­si­bi­lity of the plan’s pre­mi­ses, the mana­ge­ment’s hand­ling of the plan, and rea­di­ness of the books to pro­vide the necessary num­bers and facts for plan­ning.
 
Risk fac­tors in a due dili­gence inves­ti­ga­tion
Espe­cially in the case of invest­ment pro­jects, finan­cial due dili­gence focu­ses on the ques­tion of whe­ther busi­ness plan­ning seems rea­listic. The fol­lo­wing pit­falls have pro­ven to be the most com­mon in practice.
Hockey stick pro­jec­ti­ons fore­cast dou­ble-digit growth rates for the future even though past growth rates for both reve­nue and ear­nings have been modest. In such cases, the mana­ge­ment needs to be able to exp­lain what facts they’re basing their high hopes on.
Ano­ther pos­si­ble pit­fall is the lack of a posi­tive trend in the cur­rent fis­cal year. While a posi­tive trend in order intake or pro­duc­ti­vity indi­ca­tes that the fol­lo­wing year could turn out just as well, the oppo­site trend or even a slump in essen­tial key figu­res ser­ves as a clear war­ning sig­nal. Mana­ge­ment needs to be pre­pa­red to give solid coun­ter­ar­gu­ments.
It is also com­mon for future costs to be unde­re­sti­ma­ted. In such cases, it’s important to come up with a plau­si­ble and detai­led cal­cu­la­tion. Expan­ding into new mar­kets requi­res capi­tal and time. Cre­di­ble busi­ness plan­ning needs to include both start-up costs and lead times.
Finally, cer­tain necessary invest­ments are often not (suf­fi­ci­ently) taken into con­s­i­de­ra­tion: espe­cially the acqui­ring of new means of pro­duc­tion crea­tes a sub­stan­tial need for finan­cing. This needs to be ref­lec­ted in balance sheet and cash flow plan­ning.
The need for available finan­cial resour­ces should also not be unde­re­sti­ma­ted. Expan­ding a com­pany’s ope­ra­ti­ons usually leads to an inc­rease in receivab­les and inven­to­ries and ties up wor­king capi­tal – an area in which com­pa­nies often plan too opti­misti­cally.
And last but not least, the qua­lity of finan­cial mana­ge­ment and acco­un­ting is important: pro­fes­sio­nal repor­ting that yields relia­ble figu­res every quar­ter is not some­t­hing for medium-sized com­pa­nies to take for gran­ted. Today’s finan­cing banks tend to place hig­her demands on repor­ting, and the acco­un­ting of many mid-sized busi­nes­ses is not pre­pa­red to meet these demands. Many com­pa­nies do their own day-to-day book­kee­ping and leave the annual finan­cial sta­te­ments to their tax advi­sors. It pays off here to get the books in order in advance by brin­ging in exter­nal con­sul­tants. Other­wise, due dili­gence won’t be able to pro­vide inve­s­tors with a suf­fi­ci­ent basis for making a deci­sion, and it may also take some time after a tran­sac­tion before the inves­tor is able to imp­le­ment a func­tio­nal acco­un­ting sys­tem again. Until that hap­pens, the com­pany will find its­elf flying blind – someti­mes with fatal con­se­qu­en­ces.
In order to recog­nize and deal with these risks while con­duc­ting cor­po­rate tran­sac­ti­ons, both buy­ers and sel­lers need an expe­ri­en­ced advi­sor by their side. We know the needs of inve­s­tors in mid­si­zed com­pa­nies and we deve­lop our ana­ly­sis and repor­ting along those lines. In con­junc­tion with our cli­ents, we define the scope of the inves­ti­ga­tion accor­ding to the parti­cu­lar goals, occa­si­ons, and situa­ti­ons that they are dea­ling with. The approach of our tran­sac­tion spe­cia­lists can be descri­bed as hands-on, prag­matic, and to the point.

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