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More M&A = More Due Diligence

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LearningObjectives:

SegmentOverview:

Field of Study:

RecommendedAccreditation:

Running Time:

VideoTranscript:

Course Level:

CoursePrerequisites: Advance Preparation:

Auditing

Work experience in financial reporting or auditing, or an introductory course in accounting

None

2 hours self-study

Update

See page 16.

25 minutes

Recent surveys predict a sharp uptick for corporate mergers and acquisitions for the remainder of this year, based onhealthy cash balances and pent-up demand. Marks PanethLLP’s David Greenberg and Ashleigh Wessing explain why it’snecessary, for due diligence purposes, to inquire into allrelevant aspects of the past, present, and predictable future ofthe business your client may be purchasing.

Upon successful completion of this segment, you should be able to:● cite the reasons for an uptick in M&A activity;● provide the reasons for conducting due diligence on selling

companies;● distinguish between “due diligence” and “audit” engagements; ● identify areas of corporate activity where due diligence is

often overlooked.

RequiredReading(Self-Study):

“Good Kindling Fires-Up M&A Activity: Verizon Deal Provides Fuel”By Stephen BarlasReprinted with permission from Financial Executive MagazineFor additional info, go to: www.financialexecutives.org

“Take Note of Key Due Diligence Areas for M&A”By George D. Shaw, CPAReprinted from DiCicco, Gulman & Company LLPFor additional info, go to: dgccpa.com

See page 9.

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A. Projected Uptick in 2013 M&AActivity

1. 40% of companies expect to beinvolved in M&A transaction

2. 10% of companies anticipateinvolvement in multiple transactions

B. Factors Favoring Increased M&A

1. Record corporate cash balances

2. Historically low interest rates

3. Relatively low organic growth rates

I. Mergers and Acquisitions (M&A)

A. Goals of Due Diligence

1. Confirm seller’s

a. financial information

b. any other pertinent data

2. Examine target company’s relevantsources of

a. value

b. risk

3. Identify and quantify potentialissues

a. evaluate their impact on deal

B. Short Time-Frame

1. Understand business before you “goin the door”

C. When You Uncover Any PotentialRisks Ahead of Time

1. No surprises after closing

2. Factor into adjusted purchase price

a. inherent contingencies

b. potential liabilities

D. May Also Uncover Potential Synergies

1. Example: security features oftarget’s software

a. could be used for buyer’s ownpotential customers

II. Due Diligence Objectives

A. Similarities, and Differences, withAudit Engagements

1. Planning is much more crucial

a. requires focus on buyer’s needs

2. Field work is much more truncated

a. less formal

b. identify focus areas

3. Reporting has much less emphasis

a. more formal

b. not the primary focus

B. Forensic Accounting to IdentifyPotential Risks

1. Example: no segregation of duties atkey function

C. Use of Checklists

1. Yes, important

2. But also important to customize

III. Due Diligence Process

CPA

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A. Can You Measure CustomerSatisfaction

1. With financial measures

a. does outstanding A/R indicatesatisfaction issues?

2. With non-financial data: what arerates for

a. contract renewal

b. customer retention

B. Are Companies Using Non-LicensedSoftware

1. Within their everyday business?

2. Embedded in their products?

C. Identifying Potential Tax Liabilities

1. Starting point: many companieshave identified

a. uncertain tax positions under FIN 48

b. even if they haven’t donesophisticated nexus analysis

2. Goes beyond physical presence of

a. property

b. employees

D. With Retirement Plans, Due DiligenceSpotlights

1. Future HR and coordination issues:are you going to maintain

a. higher benefit level for targetcompany employees?

2. Future financial liabilities: are yougoing to be required

a. to correct plan errors?

V. Overlooked Areas in Due Diligence

A. With Related Party Transactions, BeAware of “Sweetheart” Deals

1. With current vendors

2. With existing customers

B. Bottom Line: Due Diligence Should

1. Commence as soon as possible

2. Focus on target company

a. its industry

b. its markets

VI. Going Forward

A. Identifying Value for the Buyer by

1. Examining profitability of corebusiness

2. Considering quality of earnings

B. Pursuing a “Red Flag” Is Based onBuyer’s

1. Needs

2. Motivation

IV. Is It Worth It?

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● As the Discussion Leader, you shouldintroduce this video segment with wordssimilar to the following:

“In this segment, David Greenberg andAshleigh Wessing explain why duediligence procedures inquire into allrelevant aspects of a business your clientmay be purchasing.”

● Show the Segment. The transcript of thisvideo starts on page 16 of this guide.

● After playing the video, use the questionsprovided or ones you have developed togenerate discussion. The answers to ourdiscussion questions are on page 6.Additional objective questions are onpages 7 and 8.

1. According to recent surveys, manycompanies believe they will engage in amerger or acquisition transaction duringthe remainder of 2013. To what extent areyour clients “open” to the possibility of abusiness combination? To what extent areany of your clients currently consideringan M&A transaction?

2. Are you surprised that so many businessesare considering, or are currentlycompleting, a merger or acquisition?What reasons are most frequently cited?Are there others that should be cited?

3. Both Ms. Wessing and Mr. Greenbergrefer to their due diligence work on behalfof buyers. But how does this presentation– of what they look at in a target company– also provide a “head’s-up” for thosebusinesses that could be (or would like tobe) acquired as a target?

4. Most auditors are comfortable with thedue diligence task of confirming theseller’s financial information. To whatextent are you – and other accountants –well trained and situated to examine thetarget company’s relevant sources ofvalue and risk?

Discussion Questions

You may want to assign these discussion questions to individual participants before viewingthe video segment.

Instructions for Segment

Group Discussion Option4

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Discussion Questions (continued)

5. In due diligence, the buyer – and its duediligence team – must “jump” fromfinancial statement earnings to the“quality” of earnings.” What is thedifference between the two? How wouldyou assess the “quality” of core earningsand core assets?

6. Ms. Wessing and Mr. Greenberg cite anumber of areas that are oftenoverlooked in the due diligence process,including: customer satisfaction; non-licensed software; and potential taxliabilities. How are these issues handledby your clients’ companies? How wouldyou include them in a due diligenceinquiry?

7. To what extent are accountants in yourpractice involved in M&A, duediligence, or other transactional analysis?What skills are necessary to function inthis area? How helpful would it be forour program to update this area on aregular basis?

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s1. According to recent surveys, many

companies believe they will engage in amerger or acquisition transaction duringthe remainder of 2013. To what extentare your clients “open” to the possibilityof a business combination? To whatextent are any of your clients currentlyconsidering an M&A transaction?● Participant response is based on your

clients (their structure, their industry,their financial situation), on yourpractice (its organization and itsservices), as well as on yourperspective and experience.

2. Are you surprised that so manybusinesses are considering, or arecurrently completing, a merger oracquisition? What reasons are mostfrequently cited? Are there others thatshould be cited?● The most frequently cited reasons for

M&A are: record corporate cashbalances; historically low interestrates; and relatively low organicgrowth rates.

● Many accountants attribute theirclients’ mergers to a lack ofsuccession planning.

3. Both Ms. Wessing and Mr. Greenbergrefer to their due diligence work onbehalf of buyers. But how does thispresentation – of what they look at in atarget company – also provide a “head’s-up” for those businesses that could be(or would like to be) acquired as atarget?● Participant response is based on your


4. Most auditors are comfortable with thedue diligence task of confirming theseller’s financial information. To whatextent are you – and other accountants –well trained and situated to examine thetarget company’s relevant sources ofvalue and risk?

● Participant response is based on yourbackground, job responsibilities,perspective and experience.

5. In due diligence, the buyer – and its duediligence team – must “jump” fromfinancial statement earnings to the“quality” of earnings.” What is thedifference between the two? How wouldyou assess the “quality” of core earningsand core assets?● Participant response is based on your

background, job responsibilities,perspective and experience.

6. Ms. Wessing and Mr. Greenberg cite anumber of areas that are oftenoverlooked in the due diligence process,including: customer satisfaction; non-licensed software; and potential taxliabilities. How are these issues handledby your clients’ companies? How wouldyou include them in a due diligenceinquiry?● Participant response is based on your


7. To what extent are accountants in yourpractice involved in M&A, duediligence, or other transactionalanalysis? What skills are necessary tofunction in this area? How helpful wouldit be for our program to update this areaon a regular basis?● Participant response is based on your


Suggested Answers to Discussion Questions


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1. The first article mentions all of thefollowing recent mergers except:

a) Microsoft’s purchase of Nokia’smobile phone business.

b) Verizon’s purchase of Vodafone’sshares in its wireless business.

c) AT&T’s purchase of T-Mobile.

d) Koch Industries’ purchase of Molex.

2. According to the first reading, M&Ahas been slow in the first part of 2013due to:

a) CEO risk aversion.

b) weak balance sheets.

c) intimidating rules.

d) looming tax issues.

3. According to the second reading,common trouble spots that could impactthe assessment of a deal’s cash flowinclude all of the following except:

a) inventory.

b) A/R quality.

c) unrecorded liabilities.

d) long-term debt.

4. Wessing mentions all of the followingways for companies to use their excesscash except:

a) paying off debt.

b) buying a company.

c) paying out dividends.

d) buying back shares.

5. Recently, corporate M&A transactions:

a) have seen a huge uptick.

b) have come under fire.

c) have declined.

d) have become increasingly attractive.

6. Due diligence includes all of thefollowing phases except:

a) negotiation.

b) fieldwork.

c) reporting.

d) planning.

7. When going through due diligence,buyers should give special attention to aseller’s:

a) GAAP earnings.

b) core earnings.

c) one-time items.

d) cash flow.

8. Red flags found during due diligence:

a) should be an indication that the dealshould not proceed.

b) should be brought to the seller’sattention.

c) should be investigated further at thebuyer’s discretion.

d) should always be investigatedfurther.

You may want to use these objective questions to test knowledge and/or to generate furtherdiscussion; these questions are only for group discussion purposes. Most of these questionsare based on the video segment, a few may be based on the required reading for self-studythat starts on page 9.

Objective Questions


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Objective Questions (continued)

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9. With regard to due diligence, companyretirement plans:

a) need to be discussed with theseller’s CFO.

b) are generally unimportant.

c) tend to be deal breakers.

d) are important to consider.

10. One of the key takeaways regardingthe due diligence process is:

a) buyers should consider hiring aforensic accountant to perform it.

b) buyers should commence theprocess immediately.

c) buyers should consider tax nexus.

d) we should expect to see more duediligence activity in the near future.

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Self-Study Option

Required Reading (Self-Study)

1. Viewing the video (approximately 25minutes). The transcript of this videostarts on page 16 of this guide.

2. Completing the Required Reading (approximately 20 minutes). TheRequired Reading for this segmentstarts below.

3. Completing the online steps (approximately 55 minutes).

When taking a segment on a self-study basis, an individual earns CPE credit by doing thefollowing:

Instructions for Segment

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GOOD KINDLING FIRES-UP M&A ACTIVITY: VERIZONDEAL PROVIDES FUEL

By Stephen BarlasReprinted with permission from Financial Executive MagazineFor additional info, go to:www.financialexecutives.org

Conditions driving mergers andacquisitions are as good as they have beenin a long time, given the historically lowinterest rates, record corporate cashbalances and relatively low corporateorganic growth opportunities.

When Verizon Communications Inc.Chairman and CEO Lowell McAdamsspoke with analysts via a conference callon Sept. 3, 2013, he said his company wasacquiring Vodafone Group plc’s 45 percentinterest in Verizon Wireless “after a decadeof anticipating.”

It was paying Vodafone $130 billion,consisting primarily of cash and stock,with about $49 billion of that total comingfrom the sale of bonds, marking it thelargest corporate sale ever. Sitting in astudio at Verizon’s operations center inBasking Ridge, N.J., McAdams explained,in general terms, why the anticipationcould now end: “The timing of this

transaction is right from both the strategicand financial perspective.”

The timing appears to be right for manycompanies. “Many corporations havetrimmed all the fat they can from theirbusinesses and are now realizing their costof capital is likely to rise. That’s one of thereasons we have been witnessing moreM&A activity,” says Kathleen Gaffney,vice president and co-director investmentgrade fixed income, Eaton VanceInvestment Managers. “If companies aregoing to finance a deal, there may be nobetter time than the present with rates stillclose to record lows.”

Microsoft Corp. announced its $7.2 billionpurchase of Nokia Corp.’s mobile phonebusiness at about the same time Verizonscooped up Vodafone’s share in Verizon’swireless business. The Verizon andMicrosoft deals overshadowed KochIndustries Inc.’s $7.2 billion purchase ofMolex Inc. one week later.

Though the Koch acquisition was the samesize as Microsoft’s, mention of itssignificance disappeared in the press theday after it was announced. As ifacquisitions in the billions had suddenly

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g become de rigueur. Deals continued to rolloff the assembly line throughout the fall. OnSept. 18, Packaging Corporation of Americaacquired Boise Inc. for $1.995 billion.

Recent acquisitions have been both sizeableand smaller in dollars but still stunning.Amazon.com Inc.’s CEO Jeff Bezos’s $250million purchase of the The WashingtonPost Co. in August is a prominent memberof the latter category, although Bezos ismaking the purchase with his personalfortune, and for cash, so interest rates aren’tan issue there. US Airways Group’s mergerwith bankrupt American Airlines (AMRGroup), announced last December, wasperhaps less of a surprise, but no lesssignificant, as two of the top five U.S.airlines could dissolve into one.

Conditions Driving M&A The soil has been fertile for these kinds ofdeals for the past year, according to GregLemkau, co-head, global mergers andacquisitions, investment banking division,Goldman Sachs Group. Speaking in awebcast in July, Lemkau said, “Conditionsdriving M&A are as good as they have beenin a long time.” He was referring tohistorically low interest rates, recordcorporate cash balances and relatively lowcorporate organic growth opportunities.

Given the current climate, Lemkau said itwas “fascinating” that there had not been,up to that point in July, no big recovery inM&A. He cited as the reason “risk aversionby CEOs,” who had become gun shybecause of big macroeconomic shocks suchas the fiscal cliff and the euro crisis. But henoticed a big sentiment change over the pastyear. “CEOs of the biggest companies aremuch more forward leaning and much moreconfident than they were six or 12 monthsago,” he said.

“They are thinking about big industry-changing transactions. Conditions are toogood and all that is needed is a period ofsustainable stability in the market,” saidLemkau. The Verizon, Microsoft, Koch andPCA deals were announced a few monthslater.

The pickup in M&A pace seems likely tocontinue barring any major economic

shocks in the U.S. or elsewhere. KPMGissues its M&A Predictor, which basespredictions on two measures: predictedforward price to earnings ratios (P/E), itsmeasure of corporate appetite, and thecapacity to transact, as measured by forecastnet debt to EBITDA (Earnings BeforeInterest, Taxes, Depreciation andAmortization). The July issue of M&APredictor included data on 362 large U.S.companies, which were among 1,000corporations worldwide included in thesurvey.

The model concluded the U.S. continues tooutperform the market, even when times aretough. Forward P/E ratios were 4 percenthigher than six months ago – modest butpositive in an uncertain market – and 14percent up year-on-year. The U.S.’s capacityto transact is robust, with an expectedimprovement of 20 percent over the nextyear. The U.S. market for mergers andacquisitions is in better shape than mostother world markets, though Japan scoredwell, too.

Companies involved in this recent surge ofM&A activity do not appear to beconcerned about the Obama administration’sattempt to block some recent mergers, norintimidated by the U.S. Department ofJustice’s (DoJ) publication of new mergerguidelines in 2010. “The changes in the2010 merger guidelines were pro-enforcement because they expanded thetheories and the types of evidence that thegovernment could use to challenge mergersraising substantial competition issues,”explains Spencer Weber Waller, professorand director of the Institute for ConsumerAntitrust Studies at Loyola UniversityChicago School of Law.

Those new merger guidelines might havebeen one factor in persuading the DoJ andsix state attorneys generals to federal districtcourt in August to block the US Airways/American merger. Justice stepped in to forcechanges to a couple of big proposedmergers since 2010, including AT&T Inc.’stakeover of T-Mobile USA, which AT&Tthen dropped, and Anheuser-Busch InBevN.V’s merger with Grupo Modelo, whichAnheuser-Busch subsequently revised inorder to gain the Justice department’sapproval.

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Just one month prior to Justice flashing a redlight to US Airways and American, theFederal Trade Commission (FTC), which isbound by the DoJ merger enforcementguidelines issued in 2010, issued anadministrative complaint challenging ArdaghGroup S.A.’s proposed $1.7 billionacquisition of Saint-Gobain Containers Inc.

The proposed acquisition would combine thesecond-largest manufacturer of glasscontainers (Saint-Gobain) and the third-largest (Ardagh). Owens- Illinois Inc. is thelargest. Together, the three companiesdominate the approximately $5 billion U.S.glass container industry. The next step inboth cases is scheduled for this fall. Anadministrative law judge will hear theArdagh case in early December.

Legislative Roadblocks Verizon, Microsoft, Koch, PCA and anyother purchaser or merger instigator issubject to the Hart-Scott-Rodino (HSR) law,which requires the Federal TradeCommission (FTC) or DoJ to review detailsof any large, proposed merger to insure itwill be pro-competitive.

A company such as Verizon submits anotification to both agencies, which decideswhich one of the two will conduct thereview. That decision is made based onwhich agency has expertise in that particularindustry area, on staff availability and otherfactors. Both agencies can go to federal courtto obtain an injunction to prevent a mergerfrom taking place.

The FTC has the additional option of forcinga company like Ardagh to submit to ahearing by an administrative law judge, whomakes a decision. Going that route can bemuch faster than going to court and it alsoallows the FTC to build a factual case thatjudge rebuffs the commission.

FTC Chairwoman Edith Ramirez told theSenate Judiciary Committee last April thatfiscal 2012 saw twice as many HSR filingsas FY 2009. In fiscal 2013, the FTC steppedin to block 16 mergers, in the energy,manufacturing, pharmaceuticals, health careand automotive industries. In a number ofthose cases, the mergers or acquisitions wereapproved when the dominant partner agreed

to divest some of the assets of the purchasedor merged company.

The Justice Department attempt to groundthe US Airways/American deal could beviewed as a little perplexing given that theGeorge W. Bush and Barack Obamaadministrations allowed six major airlineindustry mergers since 2005: U.S. Airways/America West in 2005; Delta/Northwest in2008; Republic Airlines’ acquisitions of bothMidwest and Frontier Airlines in 2009;United/ Continental in 2010; and Southwest/AirTran in 2010.

But when Justice and six attorneys generalfiled the US Airways lawsuit on Aug. 13,Bill Baer, assistant attorney general, said theUS Airways/ American combination wouldlessen competition for commercial air travelthroughout the United States. “Importantly,neither airline needs this merger to succeed,”he added. “We simply cannot approve amerger that would result in U.S. consumerspaying higher fares, higher fees andreceiving less service.”

The two airlines argue the merger is “pro-competitive.” In testimony before the HouseJudiciary Committee last February, Gary F.Kennedy, senior vice president, generalcounsel and chief compliance officer,American Airlines Inc., called the merger acombination of two complementary networksthat will offer consumers more service atmore times to more places.

“And because this will be a merger ofcomplementary networks, these benefitscome with virtually no loss of competition,”he explained. “Of the more than 900domestic routes flown by the two carriers,there are only 12 overlaps. This is one reasonwe are convinced that this merger isconsistent with good public policy.”

Clifford Winston, senior fellow, economicstudies program, The Brookings Institution,has studied the U.S. airlines industry. “Idon’t see the basis for DoJ opposition andthey have not clearly and persuasivelyarticulated it,” he says. He explains thatcarrier competition would continue to beintense and low-cost carriers would continueto put downward pressure on fares.

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Entry and exit would continue to be fluid inairline markets as a merged American andUS Airways would optimize its network byexiting some routes and entering others,while other carriers would adjust theirnetworks by entering some of the routesthat American exited and exiting some ofthe routes that they entered.

Of course, Justice’s attempt to scuttle theUS Airways/American merger has raisedconcerns over whether it will do the same inthe case of the Verizon merger withVodafone.

Robert Doyle, Jr., a partner with Doyle,Barlow & Mazard PLC and former deputyassistant director in the FTC’s Bureau ofCompetition, says: “Given that VerizonCommunications had a preexisting 55percent controlling interest in VerizonWireless, buying its remaining 45 percentfrom Vodafone doesn’t seem to change thecompetitive dynamics in the industry, sinceit won’t change the controlling interest inVerizon Wireless.”

Verizon Communications controlled VerizonWireless before the Vodafone deal, he says,and will control it after the deal. Nothingchanges, he says, “I don’t see any changepost acquisition that should raise any DOJantitrust concerns with the deal.”

A Justice challenge to Verizon would be alot more surprising than its challenge to USAirways, which itself elicited some headscratching. Whatever the level of anti-trustenforcement from the Obamaadministration, it is not impeding theannouncement of M&As, which continuedto appear through the fall, including somebig ones, such as Applied Materials Inc.’smerger with chip-equipment rival TokyoElectron Ltd., a $10 billion deal.

Barring the U.S. falling off some fiscal cliffor Federal Reserve Chairman Ben Bernanketurning off the cheap money faucet, otherblockbusters seem certain to follow.

Sidebar: U.S. Approval ofChinese Acquisition ofSmithfield Sends ‘OpenDoor’ Message

The U.S. government’s approval of aChinese acquisition of one of America’sleading food processors may have openedthe door to a broader range of foreign buy-ups of U.S. companies. In September, TheCommittee on Foreign Investment in theUnited States (CFIUS) green lightedShuanghui International Holdings Ltd.’sacquisition of Smithfield Foods Inc., theworld’s largest pork producer and processor.The acquisition represents the largest everpurchase of an American company by aChinese company.

CFIUS reviews potential purchases of U.S.companies that could threaten nationalsecurity. Its review of the Smithfield dealwas the first time the committee had lookedat a potential acquisition in the field ofagriculture.

Some members of Congress questioned thethoroughness of the CFIUS review. Sen.Debbie Stabenow (D-Mich.), chairwomanof the U.S. Senate Committee onAgriculture, Nutrition and Forestry, wasunsure, given CFIUS’s non-public process,whether issues such as the potential impacton American food security, the transfer oftaxpayer-funded innovation to a foreigncompetitor or China’s protectionist tradebarriers were considered.

“It’s troubling that taxpayers have receivedno assurances that these critical issues havebeen taken into account in transferringcontrol of one of America’s largest foodproducers to a Chinese competitor with aspotty record on food safety,” she said.

Larry Ward, a partner at international lawfirm Dorsey & Whitney, notes that “Withinthe last year, at least two deals where theacquirer was ultimately owned by a Chinesestate-owned entity were effectivelyprohibited by CFIUS and so clearance ofthis transaction may ease concerns so suchentities may feel comfortable again ininvesting in the United States.”

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gTAKE NOTE OF KEY DUE DILIGENCE AREAS FOR M&A

By George D. Shaw, CPAReprinted from DiCicco, Gulman & Company LLPFor additional info, go to: dgccpa.com

M&A has seen a recent uptick in activity.Flush with cash, corporate buyers are usingacquisitions as an attractive alternative toorganic growth, while financial buyers withrecord amounts of capital are looking fornew investments.

This increase in buyer interest has manybusiness owners exploring liquidity options.Often these owners have worked for yearsbuilding a business, and most of theirwealth is tied up in non-liquid privatecompany stock. To prepare for a liquidityevent, owners frequently ask what they cando to improve the value of their company.

As an experienced M&A advisor, we havefound that sellers can improve their dealvalue by focusing on several key areas offinancial due diligence well before anyletter of intent (LOI) is signed:

● the quality of financial information;

● the sustainability of cash flow;

● the management of tax issues; and

● the management of intellectual property.

Quality of FinancialInformation

Buyers gain confidence in the targetcompany when presented with qualityfinancial information. To minimize cost,however, many business owners opt forreviewed or compiled financial statementsrather than audited financial statements. Yetwe have found that non-audited statementsresult in significantly more negativeadjustments as a deal progresses. Since anysurprise in the historical financial resultsputs downward pressure on price, businessowners can avoid late renegotiation of the

deal terms by getting audited financialstatements two years or more before theliquidity event.

Buyers also want to know the source andsustainability of revenue growth, includingwhich customers, services and productsgenerate the highest margins and cash flow.That helps a buyer understand how theacquired business will integrate into theirstrategic plans. Often the highest multiplesare paid when buyers get excited about thecustomer base and the ability to acceleratethe growth post-closing.

Internal controls are becoming a biggerdiligence issue as more public companybuyers subject to Sarbanes-Oxley (SOX)reporting are active in the M&A market.There is also increased interest in controlsby financial buyers who want to know thatthe operating cash will be protected. Anassessment of controls will identify areas ofimprovement that can be changed prior to aliquidity event.

Sustainable Cash FlowMost businesses are sold based upon amultiple of cash flow or “EBITDA”(earnings before interest, taxes, depreciationand amortization). The higher the EBITDA,the higher the price. A key focus offinancial diligence is confirming whetherthe EBITDA is real and sustainable. Mostfailed deals are due to the fact that theEBITDA reported to the buyer did not holdup in a financial due diligence review post-LOI.

Common trouble spots include inventory,the quality of accounts receivable, andunrecorded liabilities such as litigation.Moreover, the recent recession may haveshifted the customer base as companieswent out of business, changed suppliers andor consolidated. These changes can impactnot only the quality of the revenue/EBITDAbut also the quality of inventory andaccounts receivable reported on the balancesheet.

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Tax Issues

The tax structure of the deal will have asignificant impact on the after tax proceeds.Taxes can erode between 20% to 55% ofdeal value. As advisors, we often assistbusiness owners in structuring options thatwill net them the highest after tax amounts.

Managing tax risk is increasingly important.With budget deficits and fiscal pressuremany states are using audit complianceefforts to collect additional tax revenuesfrom businesses. Advance tax diligence canidentify risk areas and allow the businesstime to make voluntary disclosures orimplement compliance mitigation plans.Buyers are not only concerned withhistorical liability risk, but also what taxliability will be incurred post-closing due tobad tax management policies.

Intellectual PropertyWith the developed world becoming relianton knowledge-based economies and thevaluation of companies depending to amuch larger degree on the knowledge theyown, the value and commercial potential ofintangible intellectual property (IP) assetsare more important than ever in mergersand acquisitions.

But greater realization of the significance ofIP – e.g. trademarks, designs and, above all,patents – in an M&A valuation does notalways mean that IP due diligence is beingcarried out consistently and effectively. Inthe past, the focus in such transactions wason the ‘tangible’ assets, for which it’s easierand more straightforward to determine avalue. Today, however, the real value ofmany companies is tied-up in their‘intangible’ assets, particularly their IP. Andthat’s where the real challenges can arise.Investment bankers are not IP specialistsand the valuation of IP assets, particularlypatents, is still allied too closely toaccounting-based procedures that aredesigned primarily for valuing tangibleassets.

Historically, IP due diligence was largely aback office, ‘tick-box’ exercise based on arudimentary assessment, often conducted atthe eleventh hour. If the IP department was

consulted, they would be asked to answer aset of questions such as: “Do these peopleown the IP they say they own? Are theygoing to maintain these IP Rightsthroughout the life of the deal? Are any ofthe IP Rights licensed to a third party? Anddo we need to review these arrangementsbefore we acquire the IP portfolio?”

These basic questions haven’t changed inrecent years. What has changed is that IP isnow more frequently addressed up front inthe deal process; and, arguably, for somedeals, it’s the driving force behind thetransaction. This trend is exemplified intechnology-intensive industries where themajority of a company’s value resides in itsintangible assets. But it’s not just theinherent value of the assets that’s attractiveto potential acquirers; the deal is equallyimportant in terms of how the assets arecurrently being leveraged and, crucially,whether they can be deployed/exploited toprovide competitive advantage, secure evengreater commercial returns, fill technologygaps in an IP portfolio, and/or mitigate therisk of being outmaneuvered bycompetitors.

Take, for example, the 2011 acquisition ofNortel Network’s patent assets followingthe Canadian telecoms company’sbankruptcy. The value of the patentsprompted a bidding war by Nortel’serstwhile competitors in the telecomssector, with the eventual sale realizingapproximately $4.5bn. In January of 2012,Eastman Kodak, in the midst of chapter 11proceedings, sold its digital imaging patentsfor approximately $525m to a consortiumof technology companies. Also, in January,Ericsson announced a deal to transfer over2,000 of their patents to Unwired Planet –the company credited with inventing themobile internet – in a tie-up that creates anew channel for licensing IP.

So what are the key disciplines that need tobe employed when assessing the IP assetsof a target company?

The first thing is to start early. IP duediligence has to be top of the agenda assoon as potential target acquisitions areidentified. Clearly, it’s important to gain acomprehensive understanding of the target’s

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IP portfolio and its IP strategy – whether it’sdesigned to boost the company’scompetitiveness and drive commercialgrowth or simply to protect what thecompany has. You will also need to identifyand understand:

● The IP assets that are critical to thecompany’s ongoing and futurecommercial success.

● How the acquired portfolio willcomplement your existing IP portfolio –the gaps it will help fill and where theremay be overlap.

● Whether the patent(s) provide you withcompetitive leverage / competitiveadvantage.

● The relevance of the target’s patents –are they just for defending their ownproducts or are there patents othersmight want to license?

● The strength of the relationship betweenthe target company’s research anddevelopment (R&D), IP portfolio andproduct/service range.

● The age profile and geographical scopeof the patents – for how long and wherecan they be enforced?

● If the company is still filing patents. Ifso, what and where?

● Whether the patent portfolio is relianton only a handful of key inventors.

● Possible encumbrances – are somepatents licensed to third parties orcurrently the subject of litigation?

It is not always easy to value IP; even forIP specialists. However, by factoring inmany of the considerations above, anacquirer can start to get a feel for the valueof the target company’s IP portfolio and anysignificant upside that may exist, while alsoidentifying potential risks to future growth.

In many circumstances, the upside and/orrisk associated with the IP portfolio mayhelp to define strategies to ensure the future

success of the acquisition. Indeed, in certaincases, these factors may well drive theacquisition decision.

ConclusionInvolving experienced M&A advisors earlyin the liquidity planning process can helpimprove deal value significantly. Pre-LOIfinancial due diligence is an importantcontributor to improved deal value. If abusiness owner can improve EBITDA by$300k, it should result in a sale priceincrease of $1.5m or more. Analysis ofother areas such as infrastructureconsiderations, customer concentration,budget planning, Key PerformanceIndicators (“KPI”) and succession planningalso lead to a smoother and more lucrativetransaction. Whatever the scenario, it nolonger makes sense to keep these keyconsiderations to the eleventh hour.

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SURRAN: Not surprisingly, venture capitalists and other investors believe thatpent-up demand, along with the availability of capital, will mean a sharpuptick for mergers and acquisitions for the remainder of the year. Notsurprisingly, most analysts expect that technology will be the industrysector with the most M&A activity, followed closely by health care andlife sciences.

Not only do 40 percent of respondents to a recent survey believe thattheir own organization will be involved in a merger or acquisition in theremaining half of 2013, but more than 10 percent of companiesanticipate being involved in multiple transactions – with some as the“buyer” and others as the “seller.”

QUINLAN: Of course, many accounting firms are adept, and experienced, atadvising companies on their M&A transactions. Joining us this monthare David Greenberg and Ashleigh Wessing, from the Marks Paneth’sCorporate Financial Advisory Services team. I probably don’t have totell the two of you, but it’s a good news/bad news scenario for manybusinesses today.

The good news is that these companies have record corporate cashbalances, in a time of historically low interest rates. The bad news is thatmany of them are still experiencing relatively low “organic” growthrates. Is there a solution in sight?

WESSING: Mike, companies are looking for ways to use the excess cash on theirbalance sheets right now. They can do that by paying out additionaldividends. They can do that by buying back shares.

GREENBERG: Well, companies do have record levels of cash on hand. Although themarket is somewhat unstable right now, it is a good opportunity forcompanies to potentially look for acquisitions and mergers.

WESSING: A lot of companies are struggling with their organic growth. But oneway to grow their operations, without that organic growth, is throughmergers and acquisitions.

QUINLAN: That makes sense. So tell me: from your perspective, why hasn’t therealready been a huge uptick in M&A transactions?

GREENBERG: You know, Mike, executives got to where they are by being risk adverse.This is another area where that permeates, and it is continued. However,there are opportunities out there for companies to grow throughacquisition.

WESSING: So, a lot of times, they are looking for a more stable environment beforethey spend a lot of that excess cash and look to acquire something else.

QUINLAN: We’ll return to your commentary, David and Ashleigh, in a minute.

SURRAN: Two parties come to terms on a new deal. Both are excited over theprospects of a fortuitous outcome, but they wish to mitigate the riskimposed by this new deal. It is at this time that both parties need tomove from big-picture ideas to practical and tangible items thatdetermine the transaction’s success or failure.

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As a result, M&A transactions typically involve a great deal of duediligence. After all, the basic function of due diligence – in any merger oracquisition – is to assess the potential risks of a proposed transaction byinquiring into all relevant aspects of the past, present, and predictablefuture of the business to be purchased.

The basic goal is to make the buyer comfortable enough with the “deal”and what is being purchased. As a result, the due diligence process mustconfirm the seller’s financial information as well as other pertinent data,such as contracts and customers.

In addition, the results of the acquisition depend on how closely theultimate value captured from the deal mirrors, or exceeds, the valueenvisioned at the beginning of the process. In most cases, looking at atarget company’s relevant sources of value and risk can significantlyincrease the chances for a successful transaction.

In other words, due diligence is an investigation of the “target” business,by focusing on those matters that are material and relevant to the potentialbuyer’s investment decision.

As a result, the goal is to identify – and quantify – any potential issue, andto evaluate its impact on the economics of the deal.

QUINLAN: It seems as if every deal is preceded by due diligence. But remind me:What’s the goal of due diligence: Is it to confirm the seller’s financial andother pertinent information? Or is it to assess potential risk andcompliance issues?

GREENBERG: I think it is both, Mike. On the one hand, you have to look at the financialinformation that is being presented to you by the target company. Youhave to make sure that they are being truthful and accurate in theirpresentation.

WESSING: Due diligence procedures should be designed from the target company’sperspective to really dive into the specifics of that industry and thatbusiness.

GREENBERG: But also, you want to kick the tires. You want to get in there and really getan understanding of what is truly going on in the company. Are there anyrisks that you are not aware of before the due diligence team gets achance to go in there?

QUINLAN: Let’s make sure I understand you. You want to look at the targetcompany’s relevant sources of value. But you also want to examine theirpotential risks. That’s an awful lot of work to do in a limited time-period,isn’t it?

GREENBERG: There is a short time-frame on the due diligence.

WESSING: It makes the risk assessment portion of the project even more important:to really understand that business before you have to go in the door. Youhave to consider the industry and the market sector that that targetcompany is in.

GREENBERG: It is important that a company looking to buy another company get thedue diligence team involved in the purchase as soon as the possible, sothey can start planning and looking for the potential risks.

WESSING: Let them know ahead of time that they are looking at a particularacquisition, so that all of that risk assessment and planning process canbegin early on in the negotiations.

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QUINLAN: On one hand, you do want to make the buyer comfortable. But, on theother hand, isn’t it possible that potential operating risk – and otherinherent contingencies – might be reflected in an adjusted purchase price?

WESSING: Absolutely. That is the whole idea of the due diligence process: to reallytake a “deep dive” into the business and understand exactly what they aredoing, and how they are recording all of the financial information. Youwant to understand all of the operations and the risks that are involvedwith those.

GREENBERG: But if they are willing to take on that risk, it is something that they shouldconsider when negotiating the final purchase price.

WESSING: So, we always want to avoid surprises whenever we can. The idea is tolearn as much as we can about that target company prior to theacquisition, so that nothing jumps out at us that we were not expectingafter the acquisition. Obviously, if we learn before, then we canincorporate any of those contingencies or potential liabilities into thepurchase price and negotiate ahead of time.

QUINLAN: Of course, you might also identify potential synergies and previously-hidden opportunities. That could make the deal even more valuable to thebuyer, couldn’t it?

WESSING: Absolutely, and Mike, one of the benefits of doing due diligence is tolearn about those potential synergies in advance.

One example involved a software company that we were working with.One of the target’s large contracts was a government contract. We learned,through the due diligence process, that what made that contract sovaluable were the security features of the software that that company wasusing.

The buyer realized the value of those security features in the healthcaresector, which is an area of the market that they were also looking to getinto at the time.

QUINLAN: Your audit colleagues at Marks Paneth have explained to me the need touse three tools in an engagement: planning; fieldwork; and reporting. Towhat extent do you use a similar process for due diligence?

GREENBERG: I do think it is similar, Mike, in that you do your planning, field work, andreporting. But I think that the planning piece is much more important in adue diligence, because you need to get a real good understanding of theissues at hand.

The planning portion is when you really can focus on what is important toyour buyer.

So, in a due diligence, it is a different type of field work than it would bewith an audit. It is a little more truncated. It is a little less formal. Youidentify the areas where you want to really focus on. Those are the areasin which you might go a little bit deeper.

But it is not a full-blown audit, so you are not going to get into everysingle line-item in the financial statement.

WESSING: There is less emphasis on the report, because really what you are lookingfor is the information that you are getting from that field work.

So, the report becomes much more of a formal document at the end, asopposed to the primary focus, which is the case in an audit situation.

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QUINLAN: In these highly analytical procedures, I suppose there’s also the potentialto use the techniques of forensic accounting, right?

WESSING: Absolutely, and that is one reason that forensic accountants are typicallyhired to do due diligence work.

GREENBERG: Being a forensic accountant, we have a sharper eye on identifying areas atrisk.

WESSING: The process involves a lot less transactional testing and looking atdocuments and it is more about talking with management and listening towhat they have to say.

So, the interview process that you learn as a forensic accountant is veryimportant.

GREENBERG: For instance, I will give you a good example. When I was working on onedue diligence, there was a heavy reliance on one individual within thetarget organization. He was responsible for quite a bit of work and he hadnobody backing him up.

He had nobody helping him with what he was doing. He was really adepartment of one and he never took any time off.

Now, this is ripe for fraud and also ripe for risks going forward with thepurchasing company.

QUINLAN: I’ve seen so-called due diligence checklists. They sort of reduce theprocess to “one-size-fits-all,” don’t they?

GREENBERG: Sure, Mike. On the one hand, it is important to have a due diligencechecklist to identify those items that a due diligence team might want toperform.

WESSING: So, the checklist is very important. You do not want to be on the airplanewhen the pilot forgets a step on the checklist before takeoff.

GREENBERG: But on the other hand, it is also important that the due diligence teamthink outside the box and look for areas that are unique to that target’sindustry.

WESSING: It is also important to tweak that checklist and the procedures that you aredoing, to fit your particular industry and that particular target company.

GREENBERG: You really do not want to leave any stone unturned when you are doingdue diligence. You want to identify all the risks to the buyer.

WESSING: Each different business presents a different risk in the market that theyserve and the type of business that they are operating.

QUINLAN: Let’s assume that the target is based in the U.S. and the financial data ispresented in GAAP. Oftentimes, there’s a real “leap” between financialstatements and real-world economic value, isn’t there?

GREENBERG: There definitely is, Mike. In a due diligence, you really want to identifythe value to the buyer. So, the company might be running at a net loss.But that might be due to extraneous items, one-off income items and one-off expenses.

You really want to get down to the core business, look at how the corebusiness is doing overall and make sure that that is what is actuallyprofitable.

WESSING: While GAAP financial statements are very important, and they are usuallythe basis for calculating the purchase price, it is more important when youare going through the due diligence process and assessing the company

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that you consider the quality of the earnings that they are reporting. Thatwould mean removing a lot of the one-time revenue items, or even one-time expense items, from your net income or your EBIDTA.

QUINLAN: Let’s say that you’re on a due diligence team that’s determining thequality and the reliability of the seller’s financial statements. What sort ofindependent verification of facts does that entail?

GREENBERG: It is important that you cannot take things at face value when you look ata target company’s financial presentation. Sometimes, you need to kickthe tires and get into their warehouse. Make sure that what they arepresenting to the buyer is actually there.

WESSING: As far as independent verification, it depends on the type of business andthe assets that the business is operating with. So, in a manufacturingsituation, you would want to take a look at the equipment that they arerelying on.

GREENBERG: But if you get into their factory or their warehouses, and see that thatequipment really needs some work, that is a future capital expenditurethat the company might have to make, that they were not even aware ofgoing into the acquisition.

QUINLAN: I’m curious: what other types of due diligence – besides financial – areusually taking place at the same time?

GREENBERG: In my experience, Mike, we have worked closely with the legal duediligence team. We have also worked with the technology due diligenceteam, depending on what type of acquisition it is.

WESSING: You really want to understand the operations, and so you are going towant to bring in experts from another particular field, as is applicable.

QUINLAN: Okay, let’s say that you do come across a change in accounting methods,or the existence of unusual ratios, or some other “red flag.” How far doyou typically pursue it?

GREENBERG: Whenever we identify a so-called red flag during our due diligence we goto the buyer.

We would discuss that with the buyer immediately. Because it could besomething that the buyer was aware of already, and they do not reallywant us to go in that much deeper. Or it could be something that is notimportant to the buyer, because it is not going to affect the purchase.

Or it could be something that they were not aware of, and it could affectthe purchase. So, we need to make sure that we spend our time correctlyin our due diligence. That is really the buyer’s call.

QUINLAN: Let’s turn to a couple of areas that might be overlooked in the duediligence process. You already told me that you can verify the existence,the condition and the value of plant, property and equipment. But whatcan you do when the seller reports that their current customers are “verysatisfied” with the product or service they’re receiving?

GREENBERG: So, Mike, a lot of times, the due diligence team will ask the targetcompany if they can contact their customers, to discuss with them theirsatisfaction of their product.

WESSING: In a lot of due diligence, the customer base is very important. It isimportant to know that that customer base is going to stay with you afterthe acquisition.

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GREENBERG: There are financial measures that you can look at that indicate to you thatthere is some problem with their customer base. For instance, how longare customers waiting to pay their bills?

If they have a lot of accounts receivable outstanding, that might indicatethat there is a problem with the customer base and that there are somesatisfaction issues.

WESSING: Customer satisfaction is an area where non-financial data is veryimportant. You are going to want to look at the customer pipeline and thecontract pipeline.

You are going to want to look at contract renewal rates and customerretention rates. All of that is very important to consider.

All of that can be applied when looking at the reliability and the accuracyof the company’s financial projections going forward.

QUINLAN: Let’s say that it’s a combination of product and service that the customersare receiving, such as software. To what extent can you – or do you –examine the quality of, or the potential defects in, that software?

GREENBERG: So many companies – software companies, especially – keep track of theirsoftware issues that they are having with their customers and that arereported to them by the customers.

WESSING: So, that is another good example of non-financial data where thatbecomes very important.

QUINLAN: That makes sense. But, besides defects, tell me: to what extent do youexamine the software – or any technology – for so-called “embedded”software?

GREENBERG: There are really two issues here, Mike.

Are companies using software within their everyday business that is notlicensed? The other issue is: are they embedding software in theirproducts that is not licensed?

A due diligence team needs to review the licensing agreements with allthe outside software companies that they are using to make sure that theyare legal, that they are paying their licensing fees, and that they are up-to-date.

QUINLAN: I don’t want to get involved in complicated accounting issues. But I’maware that, in recent years under FIN 48, companies have been required todisclose their so-called uncertain tax positions. How satisfactory is that interms of estimating any unpaid state and local tax liabilities that the sellermay have?

GREENBERG: It is an interesting question, Mike, because FIN 48 requirements really arethe items that are identified by the company as being “uncertain.” But thetruth of the matter is: they are not doing the type of review to get to thatnumber that a due diligence team might do, to identify any areas of wherethey might have sales tax nexus, for instance, that have not beenidentified.

WESSING: So, you always want to consider management’s assertions under FIN 48,but you also want to consider maybe what management has not beenaware of.

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Establishing tax nexus – whether it is sales and use tax or it is income tax– is a more complicated process than a lot of smaller companiesanticipate.

So, they have not gone through and figured out all of the jurisdictions inwhich they would be subject to tax.

QUINLAN: Let me follow up: are you interested only in those jurisdictions where thetarget company has physical nexus, such as property and employees?

WESSING: Not at all. There are a lot of additional areas that could cause a companyto have sales tax nexus, or even income tax nexus, in a jurisdiction otherthan physical presence. So, you would consider things, such as thepayment of consultants. You would consider whether employees havetraveled to the different jurisdictions, and many other considerations aswell.

GREENBERG: And Mike, it is not only state and local taxes that you need to be awareof. There are also foreign country taxes that are now coming into play aswell.

QUINLAN: In many companies, the CFO or the finance staff may have minimaldealings with the company’s retirement plan, which is under thesupervision of HR or the general counsel. How relevant are retirementplan issues to the due diligence process?

GREENBERG: It is very relevant, Mike, because the pension or retirement plan of thetarget company in many instances will not match up or coordinate withthe buyer’s plan.

The buying company needs to be aware of that, because there could besome HR issues – going forward in the company – once they merge or theacquisition is complete.

For instance, many companies today have a matching feature in their401(k) plans. If one company is matching 3-4 percent of contributions,let’s say, and the buying company does not match at all, how is thebuying company going to deal with the employees from the targetcompany? Are they going to continue the target company’s plan? Or arethey going to make them all go onto the buyer’s plan?

WESSING: Retirement plans are very important to consider when going through duediligence, not only from the cultural aspect and incorporating that newcompany into the buyer’s and integrating their staffs, but also from afinancial perspective.

So, for example, in one of the acquisitions that we did, the acquiredcompany was very small. They were offering a 401k plan to theiremployees. But the company, because it was very small, was not awarethat they needed to go through a full qualification process. Essentially, theplan did not qualify because it was “top-heavy,” which created a lot ofadditional potential liabilities for the buyer in that situation.

So, while it was also a negotiating point for the purchase price, it alsocould create some potential legal responsibilities for the purchaser goingforward.

QUINLAN: Just a few months ago, one of your partners reminded us that related partytransactions may bring the danger of fraudulent conveyances and otherunpleasant surprises. To what extent does the due diligence processexamine these issues, too?

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ript WESSING: Related party transactions are important to consider from both the

customer perspective as well as a vendor perspective.

GREENBERG: A target company might have relationships with customers and withvendors that might not continue once the acquisition is done. They have tobe aware of that information. Because if you have a sweetheart deal with avendor, that vendor may be integral to the business. If after the purchase,the vendor does not continue that sweetheart deal, it could affectoperations for the buyer.

If a customer is getting a sweetheart deal as well, and paying less thanwhat other customers are paying, they might expect the buyer to continuethat deal for them, once the purchase is over as well.

QUINLAN: You’ve covered a very wide range of issues for us this month. If ourviewers could take one thought away from this program, what would youlike that to be?

GREENBERG: I think that, in the purchase process, it is very important to get the duediligence team involved as soon as possible.

There is a better chance that the company will get all the information thatit needs to make a sound decision in the purchase process.

WESSING: I think the most important thing is to consider the business that is beingtargeted for the acquisition.

You really have to gear your due diligence procedures toward that targetcompany, toward that industry, and the market that they serve, so that youare able to identify any of the significant risks that may exist within thatcompany.

QUINLAN: Marks Paneth’s David Greenberg and Ashleigh Wessing, thanks forbringing us up-to-date on due diligence.

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