Acquiring a Business: Due Diligence Can Mean Success or Failure

Acquiring a Business: Due Diligence Can Mean Success or Failure

July 2, 2018

I’ve been reflecting on the many past engagements as I plan for new ones. It’s only natural to look forward by looking back first.

I’ve represented countless clients in connection with acquiring a business, selling a business, and entering into joint ventures over the past 30 years.

I have successfully concluded over 300 business transactions of all types and sizes, for clients large and small, public and private, local and national.

I’ve assisted more clients in acquiring a business than anything else, probably because I’ve enjoyed an aggressive and acquisitive clientele and have helped many clients make the all-important first acquisition.

It’s only logical to ask, “How did these acquisitions work out?” Were the buyers happy, did they profit handsomely, etc.?

Many still own the acquired businesses, and, of those who don’t, many sold their businesses for a handsome profit after generating income while owning and operating the business.

But let’s pursue this inquiry a bit further.  What about my clients who had a negative experience with the businesses they acquired with my assistance?  What was the most common cause of their disappointment?

While I haven’t done a scientific survey of this, I have no doubt that most of my clients that ended up disappointed with businesses they acquired with my assistance failed to perform adequate due diligence prior to acquiring the business.

In each of these situations of which I am aware, the contracts which I drafted covered and protected my client with respect to the problems they were unaware of pre-closing.  However, having a legal remedy is of little consolation when inadequate due diligence leaves the client struggling to address operational problems arising immediately after the acquisition.

Let me explain with these three examples, obviously not mentioning client or business names for reasons of client confidentiality:

  1.   Client Acquires Two Radio Stations

The client purchased two radio stations, one in Parkersburg, West Virginia and one in Sandusky, Ohio. However, the client failed to perform adequate operational due diligence relative to both stations and the West Virginia station in particular.  Due diligence would have revealed that the two stations were underperforming for reasons that could have been discovered pre-closing. Due to the buyer’s highly leveraged position, when the West Virginia station continued to underperform, the client was ultimately forced to relinquish both stations to the seller. This situation could have been easily avoided if the Buyer had performed thorough operational due diligence.

  1. Client Acquires Tool Business

My client acquired a tool business but failed to perform sufficient accounting due diligence before closing.  My client was not an accountant and planned to rely on his personal accountant to conduct accounting due diligence.  This decision presented two issues: his accountant’s experience was in preparing personal rather than business returns and his accountant was unavailable to perform any accounting due diligence because the closing occurred in April (the accountant’s busy season). The client learned post-closing that there was a very substantial post-closing adjustment due to him from the seller. However, the seller refused to pay it, even though it was clearly required to be paid to buyer under the purchase agreement.  The client was then forced to sue the seller to collect this adjustment, resulting in unanticipated and costly delays and expenses. If the buyer had performed basic accounting due diligence prior to closing, the post-closing adjustment could have been applied to the cash purchase price, reducing the total amount the client should have paid at the closing. This would have avoided all or a great deal of delay and expense.

  1. Client Acquires Microphone Business

My client acquired a distributor of microphones and related products. The buyer’s investment bankers represented both seller and buyer and undertook to do certain accounting due diligence for buyer. Between buyer, seller, and their mutual investment bankers, they somehow failed to discover pre-closing that (a) the company’s largest customer was terminating its relationship with the company and (b) the acquired company’s largest supplier had just put through a price increase. Both issues could and should have been addressed prior to the closing.  Further, the only reason the client even acquired good title to the business, was that he did payment to conduct first level legal due diligence. If he hadn’t paid for minimal due diligence, he would not even have had title after closing.

In each of these situations, my clients did not want to pay me or any other professionals to conduct significant due diligence.

Instead, each of these situations, the client made the penny wise but pound foolish decision to avoid hiring a professional to conduct the due diligence.  Instead, the client chose to do the due diligence himself or rely on someone unqualified to perform it. In each case, the person who was supposed to perform the due diligence was either unprepared, incompetent or simply failed to do the work.

In each of these situations, my client ended up with a contractual “right” and a “lawsuit” but with problems in the business.  In one case the business was crippled by reduced cash flows and the client struggled for a long period of time to restore the business to its condition pre-closing.  In the worst case, the client lost the business altogether as was the case with the radio stations which were ultimately relinquished to the original seller.

What’s the takeaway?

As important as good contracts and other agreements are, it’s essential for buyers of businesses to perform–and preferably have professionals perform–at least the basic due diligence relative to the acquired business. Issues can then be identified and addressed pre-closing, or the buyer can walk away, adjust the purchase price, or make other deal modifications.

I give my clients acquiring a business a due diligence checklist at the outset and recommend that we (the client and I working together possibly with an accountant or other professionals) conduct rudimentary due diligence. I highlight the areas I’d focus on.

In essence, we’re talking about buying a used car and I’m suggesting taking the used car to a trusted mechanic for a thorough inspection before buying it, whether or not the used car come with a warranty. For any and all problems are best discovered and addressed at the outset. Prevention better is than cure!

With all of that said, I can lead a horse to water, but I can’t make it drink. As recently as a week ago, I assisted a client with an acquisition and the client didn’t even want to wait for me to spend $5 to check whether the corporation to be sold was in good standing or to order a basic lien and judgment search.

Overwhelmingly, my many clients who have acquired businesses with my assistance over the past 30 years have done well with/benefited from the acquisitions. Of the few clients that have experienced difficulties with those acquisitions the common theme was that the client performed inadequate due diligence prior to closing the acquisition. While all of these clients were fully protected by the purchase contract relative to the issues they failed to discover pre-closing, these contracts only give the clients the right to assert a claim or file a lawsuit.  This is no substitute for addressing the problem up front or avoiding it altogether.

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