expanding the nature and scope of due diligence - CiteSeerX

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The American Management'Association (AMA) has estimated that 7500 companies ... liabilities to the acquiring company and, in some environmental eases, ..... Software is also considered to be a technology issue, and one that can be costly.
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EXECUTIVE FORUM

EXPANDING THE NATURE AND SCOPE OF DUE DILIGENCE M I C H A E L G. H A R V E Y Puterbaugh Chair of American Free Enterprise R O B E R T F. L U S C H Helen Robson Walton Chair of Marketing Strategy

INTRODUCTION Many prominent deals of the 1980s were done with cursory due diligence, which resulted in acquisitions and/or mergers that produced sobering results. The probability of a successful "corporate marriage" through acquisition or merger is only about 50% (Kroener and Kroener 1991). The American Management'Association (AMA) has estimated that 7500 companies are involved in mergers or acquisitions annually (Bohl 1989). The AMA survey also reported of these annual transactions that within 12 months nearly 25% of mergers and acquisitions confront declining productivity; nearly one of every six companies established through merger or acquisition loses market share; one of every four faces declining profitability; and that these same companies experience high employee turnover (Bohl 1987, 1989). Consequently, buyers in the 1990s demand more hard, in-depth knowledge about their acquisition targets before proceeding ("How" 1993). Nonetheless, it is a bit disquieting that a more comprehensive model of due diligence has not emerged. This article attempts to overcome this paradox. A variety of reasons can help explain the need for an expanded due diligence framework. Increased requirements by lenders and environmental liability issues should provide the impetus for the potential acquirer to conduct due diligence that provides operating, environmental, management, marketing, and systems information, as well as the standard financial and legal data. This need for more "actionable" data will become more imperative as firms move offshore to make acquisitions (Kissin and Herrera 1990). Many companies in the 1980s found that the cost of the acquisition was not what was paid for the company, but rather, all that was paid after the company was purchased to remedy problems not uncovered

Address correspondence to Michael G. Harvey, College of Business Administration, University of Oklahoma, Norman, OK 73019-0450. Joumal of BusinessVenturing 10, 5-21 © 1995 Elsevier Science Inc., 655 Avenueof the Americas, New York, NY 10010

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during due diligence (Davidson 1988; Jarrett 1989; " M & A " 1993). An additional reason for comprehensive due diligence has been the post-acquisition problems that have surfaced due to the large number of "stock deals" transacted in the 1980s, which passed undetected liabilities to the acquiring company and, in some environmental eases, to their lenders. Also, the Tax Reform Act of 1986, which altered the tax treatment between stock and asset purchases, has stimulated purchasers to become more "diligent" in their due diligence process (Gates 1988). Other due diligence issues will surface with the number of companies looking to make acquisitions in the international market. Mergers and Acquisitions sponsored a recent survey in which three-fifths of the respondents reported that the unification of the European Community had prompted them to make or plan acquisitions overseas (Kissin and Herrera 1990). The enactment of the North American Free Trade Agreement should also stimulate the increase in international acquisitions. In brief, the nature and scope of the due diligence process need to be examined in light of these trends. Importantly, this will help to ensure that the traditional method of investigating a potential acquisition is not perpetuated into the international marketplace of the 1990s. In an effort to examine the due diligence process, this article reviews the traditional approach to conducting due diligence. We highlight additional data that are needed to develop a more comprehensive understanding of the potential acquisition candidate. The expanded due diligence process to be developed will focus on intangible assets and the auditing procedures to collect needed information. The final section recommends the composition of a due diligence team. A concern for team composition underscores the need to broaden the scope of the due diligence process to help ensure successful acquisitions in the future. LEVEL OF DUE DILIGENCE A variety of issues can directly impact the level of due diligence conducted during the acquisition process. These issues can be categorized as time restrictions, cost constraints, and situational factors.

Time Restrictions Time restrictions have been of paramount importance in many deals. When this constraint is present it is often the case that the effective examination of the target acquisition--beyond the major financial, legal, tax, and future sales projections---does not occur (Crisafio and Schliebs 1989). These time limits may be placed on the acquirer by the seller when there is a seller's market ( " H o w " 1993).

Cost Constraints Quite often it has been viewed as "too expensive" to bring in experts in every functional area to render an opinion (Hearne and Dean 1989). Cost constraints are usually a function of the size of the deal. If the deal is relatively small then it will be viewed as uneconomic to invest a lot in due diligence because the personnel involved will have other things they can be doing that are more important. Both time and cost constraints also need to be viewed in terms of using warranties and representations to remedy problems that are not uncovered during the due diligence process (Harmon 1992). It is important to note, however, that the contingent liabilities and environmental consequences of poorly researched acquisitions necessitates a fully articulated due diligence process (Davidson 1988; Hearne and Dean 1989; Rechtin 1992; " H o w " 1993).

DUE DILIGENCE 7 Exhibit 1. Due Diligence Dimensions and Environments

Internal Environment

External Environment

Tangible * cash • plant equipment • accounts receivable • patents/trademarks • technology • inventory

Tangible • share of market * supplier/distributor contracts * physical location

Intangible • quality of leadership • training of personnel • corporate culture • quality of infor./analysis operating system • loyalty of personnel • trade secrets • data bases • personal/professionalnetworks

Intangible • brandproduct awareness • customer loyalty * competitive positioning

The legal implications associated with not adequately conducting due diligence are being chronicled in the business press as the "deals" of the 1980s are going bad (Davidson 1988; Jarrett 1989; McGroarty 1992; Harmon 1992).

Situational Factors A variety of situational factors, most notably foreign acquisitions (Kissin and Herrera 1990) and hostile takeovers (Milligan 1990), have been said to warrant a shortcut to the due diligence process in the past. The competitive nature of bidding for a company has required less than well-articulated due diligence.

MODIFYING

THE NATURE OF THE DUE DILIGENCE

PROCESS

An expanded due diligence process should examine intangible as well as tangible assets of the target company. These intangible assets are in both the firm's internal and external environment. Exhibit 1 illustrates the internal and external environments and examples of assets that need to be assessed during a due diligence process. The focus of a traditional due diligence process has been the tangible, internal environment. Financial and legal experts audit the "hard assets" and attempt to determine potential liabilities or future projected growth scenarios after the company is acquired. The attention of the auditors, e.g., lawyers and accountants, is primarily focused on verifying historical data and affixing value to the tangible assets of the company. Their attention on liabilities or contingent liabilities sometimes biases the due diligence process toward a negative orientation. This skepticism has been highlighted by the increase in environmental liabilities that have negatively impacted acquiring companies as well as their leaders (Hearne and Dean 1989; Green 1992). The information, which has not been historically included in the due diligence process, is normally considered to be intangible, "soft" assets of the company. These internal soft assets, i.e., quality of management, personnel, corporate culture and customer loyalty, are essential elements in the future success or failure of the acquisition. By examining intangible

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assets such as: (1) intellectual property rights; (2) trade secrets; (3) contracts and licenses; (4) databases; (5) personnel and organizational networks; (6) organizational culture; and (7) the "know-how" of employees and managers (Hall 1993)--the impact they will have in the future becomes apparent. The capabilities of the target company are inexorably linked to the intangible dimensions of that organization. Competitive advantage can result from the skills and experience of employees, knowledge bases and the capabilities of others--suppliers, distributors, lawyers, accountants, advertising agents in the value chain (Porter 1985; Hall 1991). Therefore, the reputation of the company, product loyalty among customers, and brand reputation all have value in projecting future sales of the company (Hall 1992). The intangible assets of a company can be classified into six categories: (1) the "having" capabilities, e.g., products, distribution, reputations; (2) the "doing" capabilities, i.e., knowing how to do something, leadership; (3) "people dependency," e.g., reputation; (4) "people independency," e.g., databases; (5) protection by law, e.g., trademarks; and (6) no protection by law, e.g., organizational networks (Hall 1993). It would be difficult to argue that these intangible dimensions of a company would not impact the attractiveness, purchase price, or future value to the acquiring company. There are even significant tax issues associated with these intangible assets. The concept of "goodwill" has been a concern for acquisition-oriented companies due to the tax consequences of purchasing another company. The amount paid for an acquisition above the tangible assets of the company is classified for tax purposes in goodwill. The attributed soft assets are then written off over 20 years. But, if an intangible asset can be shown to have value, it can be written off as a part of the purchase price. For example, amortizing customer lists as intangible assets and not carrying them as "mass" assets of the company has important tax implications. It has to be proven that the asset (customer list) has a limited life. If the company can establish that the intangible asset has an ascertainable cost basis separate and distinct from goodwill and a limited useful life can then be estimated with reasonable accuracy, the asset can be amortized ("Plan" 1990). The Internal Revenue Code Section 167(a) states that a reasonable allowance for exhaustion or wear and tear of property used in trade or business is permitted. The term "property" includes intangible assets, and the rules for depreciation deductions for intangibles are set forth in the Treasury Regulations: Section 1.167(a)-3. The measurement of intangible assets becomes critical in the due diligence process. Without adequate attention placed on these intangible assets, the true value of the acquisition cannot be determined and the tax consequences may have significant implications in the future ("M&A" 1993). An additional justification for including intangible assets in the due diligence process is to enable the acquisition team to defend the purchase price being paid for the new company. Not only is this "defense" necessary internally to the board-of-directors and senior management of the firm, but also to lenders involved in the acquisition. In many cases, the value of technology licenses and/or technology process, as well as intellectual property rights, are critical to justifying the price of the deal to interested stakeholders (Gilbert 1992; Rechtin 1992). Due diligence must be expanded to incorporate intangible dimensions of the potential acquisition. EXPANDING THE SCOPE OF THE DUE DILIGENCE PROCESS The scope of due diligence for the 1990s needs to be defined to identify domains of information that are required to make a more informed acquisition. Exhibit 2 depicts seven fields that need to be investigated in a comprehensive due diligence process.

DUE DILIGENCE 9 (1) Macro-Environment Audit (2) Legal/ Environment Audit

Target Acquisition (3) A%adi~eting