An Outside Director’s Considerations for Acquisition Due Diligence

Questions for Directors to Ask When Considering an Acquisition

As an outside director, you should have a clear vision of when it makes sense for the management team to pursue acquisitions. It is not uncommon for management teams to fall in love with an acquisition target, which softens their critical thinking, at a time they need to be sharp. These three questions tend to sum it up:

• How does it increase the value of the business?
• How does it increase the competitive advantage, or defensive moat, of the business?
• Is there enough reward to justify the time and risk of the deal?

It is still true that sometimes, the best deal is the one you walk away from.

Questions to Consider in the Acquisition Due Diligence Process

To make it easier, here is a sequence of questions I like to ask to see if the logic proves out.

1. What is being acquired and why does it make sense to buy?

You need to start by defining what is being acquired, and why it makes sense to the buyers’ owners. So, revenue, EBITDA, growth rates, debt levels, industry growth rate, competitive factors, and management talent shoulddiscussed be discussed in the first 30 minutes. If these are not stunningly compelling, you may want to walk away. This question needs to be remembered throughout the process, as diligence will add to, or take away from, the attractiveness of the deal. It is important to remember the original thesis as the deal process marches on, to avoid mission creep.

2. Financial projections

Once you have set the stage, it is time to see if the numbers make sense. Building an integrated financial model is no small task. That is one benefit of working with either buy-side or sell-side investment bankers or brokers. They get paid to build a good model.

As a fiduciary, you will direct management to run numerous sensitivity scenarios to develop your own judgement of how much stress the combined entity can handle. How much debt can the business support and still have enough margin of safety with its lenders? You know there will be a downturn, you just don’t know when and how bad it will be.

3. Stock vs. asset deals

The form of the transaction is the next question. Asset deals can be fairly clean. Stock deals become more complicated. In an asset deal, the buyer can value individual assets and that becomes the price. In a stock deal there are more intangibles to value, so more risk to the buyer. That is why earn-outs are common; they are a way to share the risk, and keep the seller focused on making sure the buyer gets what was agreed upon.

4. Escrow, Baskets and Caps

As the lawyers get to work, there will be discussion around earn-outs, escrow, baskets and caps. These are legal mechanisms to apportion risk between the parties. Things can and do go wrong after the deal, and buyers want a mechanism to force sellers to pay for issues that are their responsibility.

In each contract there will be representations & warranties from both parties, as well as indemnifications. On the sell side, both the company, and the owners, are likely required to make representations and warranties. If there is a default on ownership issues after the deal, there is no business to pay for the sellers’ legal defense and payments.

To address this need, insurance companies have developed rep & warranty insurance to cover approved claims. Buyers like R&W insurance since it makes it easier to price a deal, and to know there are funds to pay future claims. Sellers like R&W insurance since it helps them to sleep at night.

Board members likely should not be involved in this level of detail, but should put their nose in to assess how the risks of the deal are apportioned between the parties. No matter how hungry a CEO may be for a deal, it is the board’s responsibility to approve it.

5. Capital Stack Considerations

Other than risk, perhaps the most important decision for an outside director to consider is how the acquisition impacts the firm’s capital stack. Finding the ideal (WACC) weighted average cost of capital is a responsibility of the board . What is the most efficient way to finance the combined entity? If it is a family business, it is likely that new equity is not available to finance the deal; and there is a limit to how much debt the firm can take on.

6. Deal Execution

Strategic clarity keeps the buy team focused, and prevents “shiny object” syndrome. See item #1 above again.

If the strategy and planning are good, and the deal makes sense, it will likely get done. If buyers or sellers don’t spend the time up front to be thoughtful, it is more likely that time and money will be wasted on a deal that falls apart along the way.

As Yogi Berra famously said, “it ain’t over til its over.” Buyers can “flake out” for any reason, or no reason at all. Sellers may decide at the last minute that they just can’t part with the family legacy. It all happens.

As the buyer’s fiduciary, your role is to provide focus and clarity, before voting to proceed with the acquisition.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following webinars: Structuring and Planning the M&A Transaction and The Effective Director.]

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