Buyer’s Perspective: Due Diligence

Buyer’s Perspective: Due Diligence

Shoot the Moon
Shoot the Moon
Buyer's Perspective: Due Diligence
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Mike Harvath  00:07

Hello, this is Mike Harvath with Revenue Rocket and our shoot the moon podcast. This week we’re talking about due diligence by side due diligence. How much is too much to execute your due diligence to successful closure while mitigating risk as a buyer? With me today are my partners, Matt Lockhart, and Ryan Barnett. Ryan, I’ll turn it over to you.

 

Ryan Barnett  00:34

Yeah. Hey, good morning, Mike. And thanks for having us again. Today. As we look at deals and progress, you typically have interested parties and those interested parties come along, and they learn about you along the way. And as a buyer, you’re looking at perhaps a number of deals. But once you sign an LOI, and you’ve executed the the general terms of a deal, a big portion of how that deal actually gets completed. And between an LOI getting signed, and the execution of definitive agreements, buyers are looking to do due diligence. And today, I really have a bunch of questions about the due diligence process, when we should be looking at it, how much what it is, what’s the right amount, and hopefully, we can give some buyers insight into what sellers are thinking about a little bit, when I think about due diligence, as well as recommendations on what buyers are, what buyer should do in putting together for the right, due diligence and the intent of what due diligence is meant to do. So with that, Mike, just tell me, what is due diligence, give me a definition of what due diligence is?

 

Mike Harvath  01:41

Well, due diligence has everything to do with understanding the business that you’re about to acquire and understanding their financials in depth, as well as the business operation, if you’re going to acquire them. You can think of it as it’s a kin to a test drive of a vehicle you’re contemplating on buying, you want to get a feel for the vehicle, how does it drive? You know, does it fit your needs? Does it have the options you want? Is there good fit and finish? We’ve often said that deals have to fit financially, culturally and strategically in order to get done. The due diligence process vets do they fit in all three areas. And as you can imagine, the diligence list has to touch on all three areas, not only financial, which seems logical, but also on culture, and on strategy. In the end, if you understand those things well, and you can see a path to integration, then you’ve done an adequate job of due diligence.

 

Ryan Barnett  02:55

But maybe, maybe to back up a tiny bit here. And so what I heard you say is to diligence isn’t a way to prove the strategic bet. When I think of due diligence, I actually think about it a little a little later in the process. When we’re thinking about crafting an LOI, we want to make sure we have strategic and cultural fit first, then financial fit kind of fits into that into that equation to help us come up with a letter of intent. And I’m wondering, if we just look at due diligence, which is typically how do you prove what is what the firm is, and what you’ve committed to buying? I’m kind of curious, you know, what is due diligence before you get an LOI And what’s due diligence after an LOI? Like what kind of due diligence? Do you need to even get to an LOI stage? And what are questions that are just way too far before that LOI is even issued?

 

Mike Harvath  03:50

Yeah, that’s a great question, because a lot of times buyers get this wrong. So it’s important to know that you will have to make some assumptions around cultural fit and strategic fit. To get your LOI done, you shouldn’t necessarily be making many assumptions. Although some prior to coming up with a value of the business, you should do enough due diligence pre LOI to come up with a fair value and deal structure that everybody can agree to. So when you think about pre LOI, a lot of the diligence activity has to do with gathering information to actually structure a transaction from a financial perspective. You’re going to do some meetings and have some conversations with a seller to determine cultural fit and strategic fit, but those are somewhat preliminary. And I think post LOI it’s much more in depth diligence on all three areas financial to prove out that the financials they proved and sent to you are accurate. It’s cultural to get really into talent work with these people, do they align with our values, can we ultimately get to the place, so we’re going to that we assume we can. And, you know, strategically, they should be aligned based on kind of one plus one equals three, or one plus one equals four, cross selling opportunity, your ability to, to see a different destination together, then you can get to a part. And you have to prove those out to the best of your ability.

 

Ryan Barnett  05:36

Matt, lets look at your take on pre and post and anything added to what Mike just said.

 

Matt Lockhart  05:42

Yeah, I think that it fits. Clearly, there’s an aspect of assessing all of those fits right out of the gate, right. And culture can be some of the squishiest. And I think it comes from, you know, spending time together. And there are some things that we guide our clients on, you know, with respect to management practices, growth mindset, you know, how conservative or not conservative our leaders, you know, etc, etc. And all of those things can start to be assessed, you know, in that pre loi, dating process, you know, from a strategic perspective, you you see the offerings and or the capabilities, the combination product and service capabilities that a firm is delivering upon you, you’re able to assess that via the customer relationships in the pre LOI process, right. And then, you know, financially, you’re getting information, a level of information related to, you know, EBITA, and growth and revenue, and all of those things that happened in that pre LOI process. And then, you know, it’s assessing after the loi, it’s about verification. Right, is everything that we thought that we understood, are we verifying that? And I think that, you know, when Mike talks about what’s the right amount, right, you’re verifying it on a risk based approach. And so, you know, what do we mean by that, in the post LOI process, right, you are verifying that, you know, what is sold, you know, matches the contracts that are in place, right. after the delivery of the services and or products, then, you know, it is coming through in their standard invoicing process, you know, and then it results in, you know, cash flows on the balance statement. That’s, that’s an appropriate risk based approach to understand that what we assessed in the pre LOI process, right, is is coming forward in the post LOI due diligence process. As opposed to, you know, in the post LOI due diligence process, we’re going to take an audit based approach, right, to that financial verification. And, and we would guide against that in most cases, right? Because that is, it’s not necessary to meet the due diligence verification process. That’s just one example of saying, Okay, you’re assessing pre LOI, and then you’re verifying post LOI.

 

Ryan Barnett  08:44

I think that’s really, really well put. And I think if we’re doing good advice to buyers on the LOI, and due diligence, pre LOI, you want to make sure that you’re confident in somewhat of the numbers that are given, and you should be able to produce an LOI. That is, by the way, non binding, I think that’s a huge portion of this, in which do in further due diligence will vet out the deal. And if you ask for too much due diligence before that LOI is done, you lose the faith and trust of the seller. I’ll give a very specific example. A client list or naming of clients will typically not come out pre LOI should never really come out pre LOI, but that’s something that could be identified late in the process in due diligence.

 

Matt Lockhart  09:37

Brian, I think that you brought up you know, a really important point, which is trust, you know, throughout the entire process. It’s just a building of trust between the buyer and the seller, and, and specifically a building of trust by the leaders within those organizations, right? And, you know, we in our job as the advisors. And because we are, have been involved in hundreds and hundreds of these scenarios and, you know, literally have dozens and dozens going on today, we’re able to sniff out, right? If there is on either side, red flags or warning symbols, that would indicate that there’s sort of a reason to be distrustful on either side. But in most cases, it’s not. In most cases, you know, when parties are looking at merger and acquisition activities, they do want to be forthright, right, because they are very much looking for the most appropriate fit on on both sides. Now, from a buyer’s perspective, if you go in and you are completely skeptical, out of the gate, right, and and you think that every potential seller is wanting to pull the wool over your eyes, right, well, that’s gonna come across, and you’re gonna have a really hard time being attractive to sellers, and, and building that trust that is so crucial to building that cultural fit. Right. And so I think that that’s just a really good point that you brought out, Ryan.

 

Ryan Barnett  11:33

Thanks, Matt. Also, I’d love to talk about the types of due diligence that we see buy or sell this week, look at two specific examples. One due diligence list we had had 12 questions that was it. We opened up another due diligence request on a different project. Signed LOI in both cases, and the due diligence list was 12 pages of probably 12 questions per page. Mike, I love to, you’d mentioned something that when you saw that longer due diligence list, it gave you confidence that the buyer was in least more serious in the process. And I’d love to give your get your opinion on what what should that initial list look like, from and how can that help gauge the success of a potential close?

 

Mike Harvath  12:29

Yeah, sure. So, you know, you think about as a buyer, which you’re looking to discover, right? In diligence, and if I think if it checks these boxes, and you’ve got it, right, you know, are the financials accurate? A huge component of that is looking at the end, verifying the value of the cash flows, because in our industry, and IT services, we value businesses on the value of those cash flows, multiples of EBITA. So you need to make sure that those cash flows are accurate, you need to make sure that the statements you have have been tested to be accurate. And now a seller’s gonna rep and warrant that those numbers are right, but you want to be confident that they are in fact, right. Because they mean, that seller may think they’re accurate and warranted, when in fact they’re not. Right. So you need to do enough diligence to be comfortable, that that’s right. Likewise, you need to be able to get to know the business and to know, know the processes in the business and be confident that there’s not undue risk associated with acquiring this business. Now, you’re gonna acquire a business as a quite a stock of the business, which, you know, may involve some additional risk and maybe not as advantaged tax position as a buyer, where you can, you know, buy assets of a business and specific liabilities. And again, both pros and cons to both of those things. And we’ve talked about some of that in the past. But when you’re doing due diligence, you need to make sure that you know, the contracts are fortified, that they’re transferable if needed, that you’re able to do so without consent, or if you have consent. So there’s some procedural things. In operations, I broadly call that operations of the business, that you need to make sure to align to your processes and procedures or even what align to the type of deal structure you’re proposing for that acquisition, and certainly an advisor like Revenue Rocket, or your lawyers can assist you in sort of determining that and betting that. And I think when you’re when you’re also and there’s a long list of those things, now, it’s easy to fall into a trap where you think more is better, right? Like, you know, I don’t know that you’re going to mitigate risk in the business. And I should also add that cultural sort of, you know, when you look at strategy and culture, strategy, a lot of these operations things kind of fall into that strategy bucket culture has to do with meeting the people and determining, can I work with these people? And do I sense that we’ll be able to trust each other, because you have to be able to chart a path to work together post transaction. And a big part of that is, you know, you feel there’s a gut tell you, frankly, that these are people I can work with. And based on other things, you would just terminated due diligence, like their turnover rate and types of employees they’ve hired and how long people have been at the business, a variety of those things. And sort of, you know, Glassdoor ratings, some of those things can probably tell you a lot about, you know, sort of their their employee care and Customer Care philosophies, which is really what you’re trying to learn. like how do we, how do we care for our clients? How do we care for our employees? How do we manage those cultural aspects of the business, but what the comment I was gonna make a minute in ago was, you know, it’s easy to quickly run into well, more is better. Let’s look at you know, every paperclip you’ve ever purchased, or any purchase you’ve actually made for the last 20 years or since your inception. And we want that document? Well, no good be a nice to know, but it’s really not a need to know. And I think understanding what the need to knows are versus the nice to knows, will help you size that due diligence list, and have it be appropriate. Because what will happen if you have a lot of nice to nose on your list, is the seller will just say no, that it’s not applicable. And I would agree that it’s probably not applicable to have to know about every single purchase of every single capital asset that was made since the inception of the business. Not don’t need to know that need to know about what’s probably not deppreciated, and might be on asset schedule in the business. But you don’t need to know every purchase, for example, that was made. And so that’s a nice to know. So always testing the diligence list as to what is a need to know basis versus a nice to know is important. And you’ll want to probably have some nice to knows in there. That will just help you integrate. And to Matt’s point earlier, you know, we don’t want to confuse integration with diligence, right? It’s not the same. And so integration planning, you may have some other nice to knows that you want. But they’re not really diligence items are more about, hey, it’d be really great if we can understand this next thing, and some of those things may have to do with facilities planning. You know, it’s great, you got to know how much sleep runway, they have with a lease for example, if you’re gonna assume that lease, but there may be other things that they may be thinking about that you don’t know about that you need to be asking a you know how you guys may be moving to home office, a lot of businesses we’ve looked at lately have captured lots of money through COVID by moving to more of a remote workforce model actually shutting down their offices. So understanding what’s on the head of those sellers, as it relates to facilities is something that’s pretty critical. It’s probably not an absolute gotta know, it sort of need to know basis on diligence, but it’s certainly a nice to know, and it’s an example of one that will help you with integration plan. So, hopefully, that’s what you’re looking for Ryan.

 

Matt Lockhart  18:57

Yeah, Mike, I, you know, let me jump on that. I mean, obviously, you know, developing the integration plan is critical and, and needs to start in, in diligence. But, you know, one of the things that we know, you know, sort of from our catbird seat is that, you know, time time kills deals, right. You know, we we really advocate, that you, you, you’ve got a manageable timeline, in due diligence, that enables the closure of the deal, right, because it you know, if it lags on and lags on and it lags on well, then you know, oftentimes the deals just don’t get done. And so when you know that there’s a strategic fit, and you feel you know, strongly enough that that you’re going to be a that there’s indications of that cultural fit You’re going to be able to continue to massage those. Right, then it is really imperative that you that you drive through that diligence process as efficiently as possible, then, you know, and so while again, it’s it’s critical that you that you identified those integration points that are, you know, it’s super important to enable the, the the transaction to close successfully, and then be able to start the integration process. Right. That’s critical. But if you want to get down this 100 point, integration plan checklist in the due diligence process, and that is going to delay the close of a transaction by two months, or three months. Well, you know, and we’ll just tell you, right, you’re risking, you know, meeting your strategic imperative.

 

Ryan Barnett  21:02

Absolutely, it’s so critical that, and it’s very easy to get bogged down in the minutiae. And to both your points that the longer list does not make, the better the deal. I got, I’ve got two other topics I really would love to hit with you guys. And one of them is should what’s the role of reps and warrants when it comes to and comparing that to due diligence? And in Mike, I know that you’ve talked about this in the past, but is there a relationship too based on what the reps and warrants typed clauses in a definitive agreement can help ease the burden of due diligence?

 

Mike Harvath  21:49

Yeah, absolutely. You know, you have to understand that a seller, and again, this is critical to work with your lawyer to make sure that the reps, representations and warranties which we call reps and warrants, representations and warranties that are made by the seller are appropriate that the language is appropriate, and that the deal is size, you know, they’re sized appropriately for the deal. And in short, what is going on? Is a seller is representing that what they’re providing you is accurate and complete, and the complete of what they know. Right? So an example would be a representation would be we know, no pending litigation, right? Based on what they know, they have to actually make that representation. Oh, if later, you buy the business and get sued, and you’ll learn that they knew about pending litigation, then you have a claim against that seller because it didn’t accurately disclose to you. So representation and warranties, warranties are things that, hey, our books are full and complete. And to the best of our knowledge accurate, right? You know, that’s pretty critical. You don’t want to determine later that there was a material off balance sheet liability that gets assumed because you’re doing a stock deal that they did not disclose. Again, super important that the warrants and warranties and reps that the seller makes are accurate. Now, they can reduce your burden of diligence, because understand that, if you have comfort, that this company you’re buying is well managed, and well, their documentation is accurate. And the testing you’ve done, as we often call the acid testing of the documents is, is good, it’s fortified, you can be more comfortable that what they are producing are most likely accurate, more likely to be accurate and those reps and warrants are, are further fortified. If you find all kinds of errors and omissions in your diligence. It’s challenging because you have to go deeper into the documentation to determine what is reality and those reps and warrants. Or it may dictate how you structure a deal with holdbacks and other things to make sure you don’t have a risk in the event that there’s an invert or inadvertent breach of reps and warrants on behalf of the seller.

 

Ryan Barnett  24:32

Interesting, it’s really interesting because I think that balances out it’s kind of an overall clause that makes the deal work. And we where we don’t see a lot of companies challenge the reps of warrants like or a deal falling through past post transactions because of that. I think it’s important to look at as far as this.

 

Mike Harvath  24:58

Yeah, I can confidently say We haven’t had a situation that I know of where there’s been a rep or warrant valuation over 20 years on any of our deals. And that’s because it diligence is done right. And the reps, representations and warranties are written properly, they’re very unlikely there’ll be a breach. Because if a seller’s forthright and not just a bad actor, they’re gonna disclose everything they know. And by doing that, you can go into the transaction, you know, heads up and eyes wide open. And that helps you manage your risk, right, where reps and warranties are really important as if you have a bad actor as a seller and they’re trying to deceive you, then you know, you’re going to be leaning on that. But I would tell you that most of the time, those types of scenarios come out in due diligence and buyers just walk away from those transactions. And I think that’s why we don’t see many violations for reps and warrants, post transaction. Interesting.

 

Ryan Barnett  25:59

The last question I have, and I either micromanage, you can certainly answer this, but when you when a firm produces an LOI, and in the terms of the deal are typically outlined, there, there’s an enterprise value, there’s considerations for the deal, perhaps some of that’s cash, some of its hold back or such. Essentially, the general framework is set and due diligence is there to prove that those numbers are achievable. Mike, Mike, or Matt? How often or should a buyer use due diligence to to retrain a deal?

 

Matt Lockhart  26:42

I thought you were gonna go there, Ryan? Man, I, we have a well, A, we hate it. How’s that? Is that strong enough? We hate when we see scenarios where, you know, and, and, quite honestly, there are bad apples out there. That approach, you know, approach it from that standpoint, where, you know, they’ll put forward an offer that, you know, they’ll claim because of the, you know, the unbelievable strategic nature of a deal. They’re gonna go above and beyond what, you know, general market valuation, you know, would have in place. And so, they, they sort of remove all competition, you know, because they’ve just made this incredible offer. And then lo and behold, right early on in the due diligence process, post LOI due diligence process, you start to see indications where they’re shooting holes, right? And in, in in the seller’s information, and they’re making indications that well wait a second, you know, this, this doesn’t line up with what we’ve heard, and so on and so forth. And you’re just seeing those indications that they’re, that they’re going to come forward and retrade. And it is it’s it obviously doesn’t build trust, it’s not the right thing to do. It doesn’t set up for a one plus one equals four scenario, and it is just plain old wrong. Right. And so, you know, we, you know, we disqualify buyers out, you know, when we get indications that they’re wanting to take that type of an approach. Now, does that mean that they’re, you know, that, that all the LOIs and the definitive agreements match up? Exactly. No, you know, there’s things that you learn that, you know, you may be rounding at the edges a little bit, but that’s not retrading, right. Retraining is where you’re fundamentally changing the offer, and the value that you’ve put forward, and it is, you got to steer clear, Mike, I know you’ve seen way more of it than me. What do you think?

 

Mike Harvath  29:29

Well, I would tell you, This mistake is made oftentimes by sellers that are going in alone, where they believe that they can secure an offer, where they don’t necessarily vet a buyer as sort of a retrader. There’s also you know, a whole community of advisors that work on behalf of sellers that try to manage this process, but don’t do a very good job. So I would just say that they accept these offers from these, I would say fairly predatory buyers. They’re typically financial buyers not to categorize them only into a category. But we typically see them as financial buyer strategics do a lot less of this, because they’re looking for a plausible transaction that they can appropriately integrate in cash flow and be fair. So, you know, for the financial buyers that do this on purpose, they feel some of them, you know, think that they just know better, right? know better than the business owner are smarter than the business owner, and feel that they can convince that business owner to take a deal to eliminate the competition that’s above market and trade it down. And it is a stated, SOP standard operating procedure for them. And so I would just caution sellers, one, I would caution you as a buyer, since we’re really talking and advising buyers here on diligence, to not do that by going to a deal heads up eyes wide open, having done enough diligence to offer a fair price. Don’t intentionally deceive a seller, that just is bad practice I, you get a reputation for that. If you’ve done it, and you try to do it on more than one occasion, it’s not going to end well for you. Because we’re we’re in a fairly, you know, small market where it gets out people know, people see that writing on the wall and this occurs. And ultimately it will be a situation where you won’t be able to get deals done, which will be known as a company that retrades Hey, and I want you know, caution sellers, good sellers need to have competent advisors to, to help them. So it’s not necessarily a bad thing, when you’re when you’re looking at a deal as a buyer to have an advisor in place for the seller. It’s working for the seller, that can give them good counsel on what a what a fair offer looks like. I think at the end that’ll help you most likely get the deal closed versus not.

 

Ryan Barnett  32:19

It says this is such a detailed conversation topic, we could probably go on for long. But with that, that’s the questions I have for you today. Matt, Mike, any parting thoughts?

 

Matt Lockhart  32:31

Well, I just say, I mean, hopefully, there’s some good guidance here. But you’re right, Ryan, it’s a much more detailed discussion. And, you know, we’d love to have it, if any of you who are listening today and and if you’ve got counter thoughts, you know, let’s talk about it. But most importantly, work with an advisor who’s, who’s been there and done that. Over to you, Mike.

 

Mike Harvath  33:00

Thanks, Matt. As reminder, Revenue Rocket is the premier growth strategy and M&A advisory to IT services firms worldwide. We’re here we love what we do. I think we’ve put together some good transactions over the years and certainly are doing so now. So if we could be of help to you certainly don’t hesitate to reach out to us at info@revenuerocket.com And with that, we’re going to tie a ribbon on it for this week, and hopefully Tune in next week when we address similar topic except more from a from a seller’s perspective. Thanks a lot and make it a great day.



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