The AMA Handbook of Due Diligence

Overview

The AMA Handbook of Due Diligence is the most complete guide available on how to properly perform a due diligence investigation — and radically improve the success rate of a pending corporate merger or acquisition. The new edition of this long-trusted resource includes a CD-ROM packed with almost 400 customizable forms and templates for recording and analyzing every possible operational or financial activity at any organization.

 

Extensively revised and updated, the book reflects significant changes in the financial landscape such as the Sarbanes-Oxley Act. There are specialized sections on joint ventures, franchises, and outsourcing, as well as new legal memo and form requirements, including data room index, preliminary diligence memorandum, and the Hart-Scott-Rodino questionnaire. Thorough and easy to use, this essential resource will ensure that every "t? is crossed, every "i? dotted…and no mistakes left out on the table.

About the Author

William M. CRILLY was the chairman and founder of Newport Pacific Associates, a firm that assisted companies in arranging mergers and acquisitions. Throughout his business career Mr. Crilly led numerous acquisitions, divestitures, and public and private financing activities, all of which required rigorous due diligence investigations. As a top management official of several public companies, he was responsible for formulating final recommendations to the companies' boards of directors. Mr. Crilly served in executive positions at Eastern Airlines, Pan American World Airways, Riegel Paper, & Bowmar Instrument Corp.

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Andrew J. SHERMAN is a partner in the Washington, D.C. office of Jones Day, a global law firm. Mr. Sherman is a corporate and transactional attorney and is a recognized international authority on the legal and strategic aspects of business growth, with a focus on mergers and acquisitions, joint ventures, strategic alliances, capital formation, franchising, and other types of intellectual property leveraging and growth strategies. Mr. Sherman is also the author of eighteen books, including Franchising & Licensing: Two Ways to Build Your Business (AMACOM, 2003), Raising Capital (AMACOM, 2005) and Mergers and Acquisitions from A to Z (AMACOM, 2006).

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Common Due Diligence Problems and Exposure Areas

There are virtually an infinite number of potential problems and exposure areas for the buyer which may be uncovered in the review and analysis of the seller's documents and operations. The specific issues and problems will vary based on the size of the seller, the nature of its business and the number of years that the seller (or its predecessors) have been in business.

• "Clouds? in the title to critical tangible (real estate, equipment, inventory) and intangible (patents, trademarks, etc.) assets. Be sure the seller has clear title to these assets and that they are conveyed without claims, liens and encumbrances.

• Employee matters - there are a wide variety of employment or labor law issues or liabilities which may be lurking just below the surface which will not be uncovered unless the right questions are asked. Questions designed to uncover wage and hour law violations, discrimination claims, OSHA compliance, or even liability for unfunded persons under the Multi-Employer Pension Plan Act should be developed. If the seller has recently made a substantial workforce reduction (or if you as the buyer are planning post-closing layoffs), then the requirements of the Worker Adjustment and Refraining Notification Act (WARN) must have been met. The requirements of WARN include minimum notice requirements of 60 days prior to wide scale terminations.

• The possibility of environmental liability under CERCLA or related environmental regulations.

• Unresolved existing or potential litigation — these cases should be reviewed carefully by counsel.

• A seller's attempt to "dress-up? the financial statements prior to sale, often in an attempt to hide inventory problems, research and development expenditures, excessive overhead and administrative costs, uncollected or uncollectible accounts receivable, unnecessary or inappropriate personal expenses, unrecorded liabilities, tax contingencies, etc.

 

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Common Mistakes Made by Buyers During Due Diligence

1. Mismatch between the documents provided by the seller and the skills of the buyer's review team. It may be the case that the seller has particularly complex financial statements or highly technical reports which must be truly understood by the buyer's due diligence team. Make sure there is a capability fit.

2. Poor communication and misunderstandings. The communications should be open and clear between the teams of the buyer and the seller. The process must be well orchestrated.

3. Lack of planning and focus in the preparation of the due diligence questionnaires and in the interviews with the seller's team. The focus must be on asking the right questions, not just a lot of questions. Seller's will resent wasteful "fishing expeditions? when the buyer's team is unfocused.

4. Inadequate time devoted to tax and financial matters. The buyer's (and seller's) CFO and CPA must play an integral part in the due diligence process in order to gather data on past financial performance and tax reporting, unusual financial events or disturbing trends or inefficiencies.

5. Lack of reasonable accommodations and support for the buyer's due diligence team. The buyer must insist that its team will be treated like welcome guests, not enemies from the IRS! Many times buyer's counsel is sent to a dark room in the corner of the building to inspect documents without coffee, windows or phones. It will enhance and expedite the transaction if the seller provides reasonable accommodations and support for the buyer's due diligence team.

6. Ignoring the real story behind the numbers. The buyer and its team must dig deep into the financial data and test (and retest) the value proposition as to whether the deal truly makes sense. They must ask themselves, "Does the real value truly justify the price?? The economics of the deal may not hold water once a realistic look at cost allocation, inventory turnover, and capacity utilization is taken into account.

 

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Overview: The Art and Science of Due Diligence

Due diligence is not just a process, it is also a reality test—a test of whether the factors driving the deal and making it look attractive to the parties are real or illusory. Due diligence is not a quest to find the deal-breakers but a test of the value proposition underlying the transaction to make sure that the inside of the house is as attractive as the outside. Once the foundation has been dissected, it can either be rebuilt around a deal that makes sense or allow the buyer to walk away and prevent the consummation of a deal that doesn't make sense.

Overall, the due diligence process, when done properly, can be tedious, frustrating, time-consuming, and expensive. Yet it is a necessary prerequisite to a well-planned acquisition, and it can be quite informative and revealing in its analysis of the target company and its measures of the costs and risks associated with the transaction. Buyers should resist the temptation to conduct a hasty "once over,? either to save costs or to appease the seller. Yet at the same time, they should avoid "due diligence overkill,? keeping in mind that due diligence is not a perfect process and should not be a tedious fishing expedition. Like any audit, a diligence process is designed to answer the important questions, and ensure with reasonable assurance that the seller's claims about the business are fair and legitimate.

Proper due diligence involves knowing:

• - where to look
• - what to ask
• - what tools to use
• - who to ask
• - how to test premises/answers
• - who should ask

 

Effective due diligence is both an art and a science.

The art is the style and experience to know which questions to ask and how and when to ask them. It's the ability to create an atmosphere of both trust and fear in the seller, which encourages full and complete disclosure. In this sense, the due diligence team is on a risk discovery and assessment mission, looking for potential problems and liabilities (the search), and finding ways to resolve these problems prior to closing and/or to ensure that risks are allocated fairly and openly after the closing.

The "Art? of Due Diligence:

• - Understanding how to extract key information from a person or situation
• - Understanding the objectives of the parties and the underlying transaction
• - Identifying key hurdles and risks
• - Identifying why information might be falsified or omitted
• - Targeting the proper sources for disclosure of information

 

The science of due diligence is in the preparation of comprehensive and customized checklists of the specific questions to be presented to the seller, in maintaining a methodical system for organizing and analyzing the documents and data provided by the seller, and in quantitatively assessing the risks raised by those problems discovered in the process.

The "Science? of Due Diligence:

• - Do your homework
• - Be prepared and well-organized
• - Be precise in your requests
• - Be persistent in your quest for the truth
• - Don't accept the first answer as the final answer

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Review Quotes

"…I have been involved in a number of transactions…this book…takes a very complicated and involved process and explains it in a way that is thorough, clear, and… concise.? - CEO Blog

"… takes away a lot of that angst…help everyone from the due diligence novice to the expert… proven track record of AMA assures…it will be a good product.?— CarpeFactum

"… treacherous course of due diligence…fraught with booby traps…having a road map on which to execute your due diligence can help …authors provide a great road map.? —Law Insider

"[T]his book can be useful for professional services practitioners looking for a refresher on various parts of the traditional M&A process, for professional services practitioners who want to build their own customized traditional forms and checklists, or for professionals or researchers looking for one of the very few books on traditional due diligence.? --Due Diligence Digest (Association of Due Diligence Professionals)

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Cover Copy

Revised & Updated Edition of the Most Complete Due Diligence Guide Ever Published!

 

If you are...acquiring, merging, selling, appraising, auditing, or underwriting a business entity or business unit, don't proceed without The AMA Handbook of Due Diligence.

 

What makes The AMA Handbook of Due Diligence so special? It's really an annotated collection of almost 400 forms - easy to use and customize from the companion CD-ROM - that allow you to record and analyze every possible operational and financial activity of the business units under investigation. Probing sequences of questions penetrate into the darkest corners…long lists of possible reasons lead you to research the background of every "fact?. All the danger signs Crilly and Sherman have learned to recognize are uncompromisingly confronted. The forms elicit such realities as:

• Projections unrealistic because of factors not taken into account

• Disputes between directors and controlling shareholders

• Management not providing directors with accurate information

• Potential losing contracts

• Changes in competitive environment

• Global economic factors

…just to mention a few of the thousands of real-life possibilities you can pinpoint with the help of this amazingly complete investigative guide.

 

Why do so many new ventures, mergers and acquisitions fail? Not because the due diligence investigation doesn't yield good answers. Rather because some important questions are never asked. Here at last is an easy-to-use system so detailed and far-seeing that no potential development is overlooked. It includes:

• Almost 400 ready-to-use forms

• Step-by-step practical guidance

• Advice on evaluating information and danger signs

• A CD-ROM with all the forms you need to perform complete due diligence

 

All this adds up to create a logical, sequenced methodology that hunts down the full and accurate truth. With probing, uncompromising insistence, The AMA Handbook of Due Diligence gives you the means to diligently pursue each detail to satisfactory closure. It gives you the power to ensure the fusion of a profitable new entity or the successful absorption of one entity by another.

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Excerpt

What's New In This Edition

 

In wake of the Sarbanes-Oxley Act enacted pursuant to the Enron scandal and subsequent events as well as the changed Mergers and Acquisitions scenario due to the credit crisis, a significant change has been witnessed in the practice of due diligence. This has necessitated addition of content in the introductory sections of the Handbook, including common due diligence problems, common mistakes made by the buyer and the art and science of due diligence that prominently reflect the practice of due diligence in current times.

 

Due diligence practice post Sarbanes-Oxley enactment deserves the addition of a separate section in view of some onerous disclosure requirements that are now mandatory. An additional section has been inserted providing checklists for potential acquisitions or investment in selected industries and/or businesses. Such checklists are provided with a view to educate audiences of special considerations in each of the businesses contained in that section to facilitate a unique due diligence process for each such business. Examples of such businesses include restaurant services, franchising companies, hospitals, outsourcing technical services, private equity and hedge funds and closely held businesses. With each such business, we seek to cater to a broad audience of the new series of the Handbook to give useful insights on warning signals before investing or acquiring such specific businesses.

 

The section on Non-M&A transactions has been added with an aim to make the new series of the Handbook comprehensive. Adequate and timely due diligence is required not just for transactions that pertain to acquisition or investment, but to joint ventures, strategic alliances, licensing technology and entering into dealership or distributorship agreements. Continuing on our intention to cater to a broad audience, the editors of the Handbook seek to leverage on their practical and legal experience in such individualized transactions and provide effective checklists to ensure that potential participants of such transactions are in safe harbor before signing on dotted lines of formal instruments.

 

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Table of Contents

Contents

 

List of Forms v

1. Preface 1

2. How To Use The Due Diligence Handbook 15

3. Overview Of Entity 21

4. Compatibility With Investment / Acquisition Objectives 29

5. Capitalization And Ownership 49

6. Organization And Management 67

7. Relationships With Outside Organizations 89

8. Description Of Products And/Or Services 105

9. Revenues And Market Share 151

10. Marketing Operations 195

11. Customer Service 261

12. Inventory Control And Purchasing 277

13. Production 311

14. Physical Distribution 363

15. Computer, Communications And Information Systems 389

16. Financial Management 419

17. Legal Affairs 469

18. Security And Safety 495

19. Human Resources 505

20. Land And Buildings 541

21. Introduction To Financial Analyses 559

22. Balance Sheet Analysis - Liabilities 565

23. Revenues 587

24. Operating Expenses 593

25. Income Taxes 613

26. Net Income 621

27. Capital Expenditures 627

28. Cash Flow 633

29. Financial Ratio Analysis 639

30. Income Statement Projections 657

31. Balance Sheet Projections 679

32. Cash Flow Projections 699

33. Due Diligence Checklists 707

34. Transaction - Specific Due Diligence Checklists For Acquisitions Or Investments On

Specific Dealings In Selected Industries 727

35. Sample Forms Related To Effective Due Diligence 737

36. Due Diligence Checklists For Special Situations 769

Appendix A: Bibliography And Recommended Further Reading 791

Appendix B: A Selection Of Blank Forms 793

Index 799

About the Authors 827

 

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