In this issue we take the mystery out of due diligence, which is simply the process of understanding, in detail, all the essential elements of a business. We explain the process in plain English and discuss a real world example of what happens when due diligence is not adequate. We also introduce a ForteCEO executive who has looked at hundreds of companies and in the process bought and integrated 15 of them into his own firm.

We have worked with business owners to help them prepare their business for sale, “recover” from a difficult acquisition, integrate acquisitions into core businesses, and run failing companies they have acquired. With each of these businesses the common theme is due diligence: either preparing businesses (and their owners) to sail through the due diligence process, or more often, helping them recover from the pain of poor due diligence. For buyers and sellers of businesses, careful due diligence pays long-term dividends.

We hope you enjoy this issue and find it useful in your business. As always, we welcome your feedback.

ForteCEO recently worked with a Midwestern manufacturing company that served big box retailers. This $15+ million company was near bankruptcy when a larger manufacturer purchased it. The purchasing company’s interest was largely based on an increased demand from their existing customer base for an expanded product line which they were currently outsourcing. With this purchase, they believed they could lower their costs by bringing this function in-house and with relative ease, restore the profitability of the smaller company.

Prior to the purchase, the due diligence focus had been primarily financial with little attention paid to other issues. There was no clear integration plan and several months after the sale, the purchaser discovered that differences between the two operations were significantly larger than their staff could manage. The parent company was an assembly operation. The purchased company was a manufacturing operation. Integrating the different cultures and operations proved much more difficult than expected.

After two years of operations the acquired company had accumulated a loss of over $1 million, and was not in compliance with loan covenants. They were also over-advanced on their borrowing base and were unable to construct a recovery plan acceptable to their lender.

At the request of the lead bank, ForteCEO was hired, immediately did a thorough assessment of the business, and reviewed the findings and recommended action plan with the owners. The business owners requested that a ForteCEO executive work with them to address the operational and financial issues. This included redefining the company operations and internal infrastructure, including: rolling cash flow requirements, job development and pricing process, communications, integration strategy with the parent operations, corporate culture, financial function, operational controls and labor practices.

Through discussion with ForteCEO, both the bank and client also agreed that within the combined companies higher level operations leadership was needed. ForteCEO helped recruit and hire a seasoned Chief Operating Officer (COO) with a relevant manufacturing background to provide the leadership necessary to continue the momentum of integrating these two companies and successfully streamlining the operations.

Through the combined efforts of ForteCEO and the new COO, cash flow is on the road to recovery, the company is on track to become profitable, and both the owners and the bank are pleased with the progress.

“Due Diligence” is a phrase that is often used and misused to cover a multitude of sins. Due Diligence (usually) defines the period of time in which an acquiring company has permission to and is encouraged to access relevant records before finalizing a deal to buy another company. During this period all assumptions about the deal are tested to make sure that everything is exactly as it appeared during the negotiations.

Due Diligence evokes concern among many small business owners for a wide variety of reasons. First, if this is their only experience in selling a business, they are anxious that the acquiring company may ask questions that are hard to answer, or will uncover something that will decrease the value of their business — or, worse yet, kill the deal. Second, accountants and investment advisors who speak a language unfamiliar to some businessmen frequently orchestrate the process. Third, due diligence can easily distract employees, cause rumors to spread, and upset key stakeholders such as customers, suppliers, and shareholders/family members.

The best way to take the mystery out of Due Diligence is to understand the process at the onset of negotiations, not after the deal has been reached. Acquiring companies may send a due diligence checklist to their prospects before entering into any serious negotiation. This helps to put the focus on critical factors up front, and reveal who the players are in the other company, and how serious they are about the deal. It can also help keep due diligence shorter and friendlier.

A due diligence checklist should solicit information about the following topics:

Product and/or Services A comprehensive list of the products and services that make up the core business and their revenue mix, and those that are considered to be ancillary. This should include items like background on the product life cycle, intellectual property, contractual obligations, patents and trademarks, sales by market by region by year, as well as the role that suppliers may have played in specific product development.

Operations For each functional area, individual operations should be categorized according to how critical they are to the function of the company. This should include detailed questions about facilities, warehousing, and storage, office procedures including documentation about operations (are the procedures for a specific operation in the head of the person doing the job or are they written down so that someone else could perform the job at the same level if  necessary), personnel profiles as they relate to specific operations, customer records.

Personnel Detailed information on each employee, salary history, how critical he or she is to the operation, and promotion potential are all important for the acquiring company to know. This is an area where small businesses in particular are not known for keeping great records. Whereas payroll records create an adequate paper trail with regard to salary history, performance evaluations are often non-existent. Having well organized personnel records will make the due diligence process smoother (and minimize the rumors that may arise from a sudden interest in documentation.)

Sales/Marketing A breakdown of customers by market, dollar volume and which products and services they purchase. Information about the level and approach to specific marketing activities, such as active customer/prospect pipeline, promotions, role of salespeople, telemarketing, conventions, special events and customer survey data.

Financial Data Inventory, capital goods, 5 years of profit and loss history, budgets and cash flow projections compared to actual cash flow, accounts receivable and payable history and aging, record of historic, active or pending litigation, and anything else that would be helpful.

In most cases, the acquiring company will not receive all the information requested. However, the amount and depth of information provided, and the reaction to the list of questions, are often a very good indication of the seller’s level of motivation. It is worth noting that the financial questions are purposely last on the list because the seller may ask questions of a similar nature in return. The seller may want to know if the acquiring company can truly afford to make an offer. The purchaser should welcome these questions and use them to learn as much as possible about a prospect and weed out those simply shopping their company.

After sending the checklist and weighing the response, it is advisable to travel to the target company and go over the checklist in person. This begins the due diligence process with much less mystery, formality, and anxiety and gives the acquiring company an edge in terms of understanding. It is critically important to keep it all confidential and make sure the key players are always involved in the process. Finally, emphasize the non-numerical answers as much as the dollars and cents.

At times due diligence uncovers hidden liabilities. Sometimes these will have only a minor effect on a deal, and sometimes they will make a huge difference. When all the players know about them up front they can determine if the sale still makes sense and/or make adjustments to the purchase price without letting it derail negotiations once a price has become “fixed” with the seller.

Many large companies have full time teams of negotiators and business development specialists. Most small businesses have little or no experience at buying or selling companies. The approach outlined here presumes everything will surface sooner or later. Consequently, it makes sense to begin the process early, identify what will be asked, and delay on some sensitive questions if necessary (acknowledging that they exist). Not only will negotiations go more smoothly, but due diligence and subsequent integration periods will be more productive and the pain will be kept to a minimum.

Upon receiving his Masters Degree in Education in 1973, Joel Altschul went to work in his father’s company that produced and distributed educational films. He could not possibly have imagined that nine years later,  he would be thrust into becoming Chairman and CEO overnight, when his father died suddenly. Nor could he have
predicted that over the next 20 years  he would grow the business into a multi-million dollar enterprise that would be purchased by Discovery Communications, Inc., a Fortune 500 Company that operates The Discovery Channel and several others. He fueled this growth both internally and through the acquisition of 15 other companies that ranged in size from $125,000 to $3.5 million; and he evaluated hundreds more as potential acquisitions. Through this process and as each of these acquired companies was in some degree of distress at the time of purchase, his many areas of expertise grew to include purchase due diligence, negotiation, business turnaround, consolidation and streamlining of operations, sales and marketing strategy and leadership, integrating corporate cultures, assessing staffing needs, succession planning, exit strategies, and the special circumstances unique to family businesses.

Joel prides himself on being extremely adept at what he calls the “management of change” and creating an environment where change is embraced. He views this as a core competency vital to the longevity of any business in any industry. Whether ahead of the curve as markets and technology change or in response to it, how change is communicated to both customers and employees must be a deliberate strategy.

When video technology was first developed, it created a sea change in terms of the educational media production and distribution business. Joel made the deliberate decision to embrace the change from film to video immediately, and therefore found he was at the forefront of a new era where other businesses wanted to follow his lead and even came to him seeking assistance. Creating “customer evangelists” who were eager to spread the word to their business colleagues proved very successful and profitable for Joel’s company. Likewise, he felt it was crucial to help his employees understand their stake in the profitable future that resulted from these changes. The corporate culture of a company (well beyond just the management team) is as important as anything that is quantifiable on the balance sheet.

What Joel also brings to ForteCEO is his expertise in all the non-quantifiable particulars that are unique to family businesses. Having to take over a family business that didn’t have a succession plan and then shepherd it through turbulent technological changes and parlay it into a multi-million dollar company has given Joel a skill-set that is diverse in both depth and breadth of experience.

Joel has a Bachelor of Arts degree from Harvard University and a Masters degree in Education from the University of Illinois. He spent time in Peace Corps teaching in the Philippines. He is married, lives in Illinois, and has 3 children and 2 grandchildren.