Your company, How Did I Miss That Corporation (HOW) has been struggling. Sales have been stagnant over the last three years and net income has started to decline. Investors are growing restless and are calling for change. One late night you stumble upon an opportunity to acquire Hook Line and Sinker Corporation (HOOK), a competitor. After reviewing the investment reporting package provided, the deal and price look good. HOOK has suffered losses over the last few years, but these losses are due to one-time occurrences and a lot of related party transactions and you believe you can reduce overhead by sharing administrative resources. You sign the purchase agreement and pay the purchase price, it’s done.
Your auditors now begin the process of auditing the opening balance sheet for inclusion in your financial report. A week into the project, the audit partner calls and informs you of a problem. All of the audit procedures performed to date have indicated the balances and information you relied upon for the purchase are materially misstated. In fact, the actual losses are twice as large as originally thought, all of the add backs are overstated, and HOOK actually has a negative working capital balance of $2,000,000. Your investors are livid and want to know why you didn’t catch this before you purchased HOOK.
Does the above scenario sound familiar? Every year, companies complete acquisitions with little to no financial due diligence. Some work out great and some are disasters leading to purchase price overpayments, impairments, and significant expenses to determine the true financial picture. In the above scenario, it would appear HOW could have benefited from some simple financial due diligence procedures.
Performing proper financial due diligence is similar to hiring an inspector to inspect your house before you buy it. I don’t know very many that would buy a house without having it inspected by a knowledgeable professional. Similar to a house inspection, there is no requirement that due diligence be done by a third party, but it is strongly recommended that an independent third party perform key portions of the work so as to draw upon an independent non-bias opinion. This third party should be fully informed of the details and specifics of the proposed transaction and be well versed in performing financial due diligence procedures. They should also have a solid understanding of Generally Accepted Accounting Principles (GAAP). The familiarity with the proposed transaction and GAAP, will allow the third party to provide a more in depth assessment, catch odd accounting complexities, and provide the most accurate and in depth analysis possible.
Depending on the level of involvement and the procedures performed, the cost to perform financial due diligence varies, but much like a house inspection it can be worth the investment. Spending $20,000 on a company you do not own may seem like a lot, but when it allows you to negotiate a better price and hypothetically save you millions, many would argue that is a great return on investment.
In our case example above, proper financial due diligence would have alerted HOW to many, if not all of the problems that were uncovered after the fact. The impact of not performing proper financial due diligence cost HOW significantly. Not only did they incur significant legal and accounting fees, but subsequently reported financial information required restatement, financial filings were late, bank financing to pay off investor debt as planned was delayed, the reputation and perception of HOW was harmed in the market, and it took over eight months to complete the audit. These consequences could have been avoided if HOW took the time and effort to perform some financial due diligence and had not rushed into the purchase of HOOK. In other words, HOW would be off the HOOK.
File Download: Financial Due Diligence, an Ounce of Prevention is Worth a Pound of Cure