The Secrets of Due Diligence - Be warned

It is always good to know whats ahead of you and if you are going run your own company that is VC funded / or otherwise funded, then due diligence will become a well know activity, this short article is on how to perform good due diligence it will help you prepare for your own. I have been through this activity more times than I can count from both sides of a deal and it is important that both sides get it correct and walk away with the right picture for the organization. Due diligence is not the sexy part of the game, but it is one of the most important things you will go through, next to selecting a good coffee machine being for the buisness (dont underestimate a good cup of coffee when everything turns to a rats nest).

Sealing the deal is the easy part. But first comes due diligence.


Here's how to calculate your target's stand-alone value. A Harvard Business Review excerpt.

by Geoffrey Cullinan, Jean-Marc Le Roux, and Rolf-Magnus Weddigen

What can companies do to improve their due diligence? To answer that question, we've taken a close look at twenty companies—both public and private—whose transactions have demonstrated high-quality due diligence. We calibrated our findings against our experiences in 2,000-odd deals we've screened over the past ten years. We've found that successful acquirers view due diligence as much more than an exercise in verifying data. While they go through the numbers deeply and thoroughly, they also put the broader, strategic rationale for their acquisitions under the microscope. They look at the business case in its entirety, probing for strengths and weaknesses and searching for unreliable assumptions and other flaws in the logic. They take a highly disciplined and objective approach to the process, and their senior executives pay close heed to the results of the investigations and analyses—to the extent that they are prepared to walk away from a deal, even in the very late stages of negotiations. For these companies, due diligence acts as a counterweight to the excitement that builds when managers begin to pursue a target.

The successful acquirers we studied were all consistent in their approach to due diligence. Although there were idiosyncrasies and differences in emphasis placed on their inquiries, all of them built their due diligence process as an investigation into four basic questions:

• What are we really buying?
  
• What is the target's stand-alone value?
  
• Where are the synergies—and the skeletons?
  
• What's our walk-away price?

[Here] we'll examine each of these questions in depth, demonstrating how they can provide any company with a solid framework for effective due diligence. [...]

Once the wheels of an acquisition are turning, it becomes difficult for senior managers to step on the brakes.

What is the target's stand-alone value?
Once the wheels of an acquisition are turning, it becomes difficult for senior managers to step on the brakes; they become too invested in the deal's success. Here, again, due diligence should play a critical role by imposing objective discipline on the financial side of the process. What you find in your bottom-up assessment of the target and its industry must translate into concrete benefits in revenue, cost and earnings, and, ultimately, cash flow. At the same time, the target's books should be rigorously analyzed not just to verify reported numbers and assumptions but also to determine the business's true value as a stand-alone concern. The vast majority of the price you pay reflects the business as is, not as it might be once you've won it. Too often the reverse is true: The fundamentals of the business for sale are unattractive relative to its price, so the search begins for synergies to justify the deal.

Of course, determining a company's true value is easier said than done. Ever since the old days of the barter economy, when farmers would exaggerate the health and understate the age of the livestock they were trading, sellers have always tried to dress up their assets to make them look more appealing than they really are. That's certainly true in business today, when companies can use a wide range of accounting tricks to buff their numbers. Here are just a few of the most common examples of financial trickery used:

• Stuffing distribution channels to inflate sales projections. For instance, a company may treat as market sales many of the products it sells to distributors—which may not represent recurring sales.
  
• Using overoptimistic projections to inflate the expected returns from investments in new technologies and other capital expenditures. A company might, for example, assume that a major uptick in its cross selling will enable it to recoup its large investment in customer relationship management software.
  
• Disguising the head count of cost centers by decentralizing functions so you never see the full picture. For instance, some companies scatter the marketing function among field offices and maintain just a coordinating crew at headquarters, which hides the true overhead.
  
• Treating recurring items as extraordinary costs to get them off the P&L. A company might, for example, use the restructuring of a sales network as a way to declare bad receivables as a onetime expense.
  
• Exaggerating a Web site's potential for being an effective, cheap sales channel.
  
• Underfunding capital expenditures or sales, general, and administrative costs in the periods leading up to a sale to make cash flow look healthier. For example, a manufacturer may decide to postpone its machine renewals a year or two so those figures won't be immediately visible in the books. But the manufacturer will overstate free cash flow—and possibly mislead the investor about how much regular capital a plant needs.
  
• Encouraging the sales force to boost sales while hiding costs. A company looking for a buyer might, for example, offer advantageous terms and conditions on postsale service to boost current sales. The product revenues will show up immediately in the P&L, but the lower profit margin on service revenues will not be apparent until much later.

To arrive at a business's true stand-alone value, all these accounting tricks must be stripped away to reveal the historical and prospective cash flows. Often, the only way to do this is to look beyond the reported numbers—to send a due diligence team into the field to see what's really happening with costs and sales.

That's what Cinven, a leading European private equity company, did before acquiring Odeon Cinemas, a UK theater chain, in 2000. Instead of looking at the aggregate revenues and costs, as Odeon reported them, Cinven's analysts combed through the numbers of every individual cinema in order to understand the P&L dynamics at each location. They were able to paint a rich picture of local demand patterns and competitor activities, including data on attendance, revenues, operating costs, and capital expenditures that would be required over the next five years. This microexamination of the company revealed that the initial market valuation was flawed; estimates of sales growth at the national level were not justified by local trends. Armed with the findings, Cinven negotiated to pay £45 million less than the original asking price.

Getting ground-level numbers usually requires the close cooperation of the acquisition target's top brass. An adversarial posture almost always backfires. Cinven, for example, took pains to explain to Odeon's executives that a deep understanding of Odeon's business would help ensure the ultimate success of the merger. Cinven and Odeon executives worked as a team to examine the results of each cinema and to test the assumptions of Odeon's business model. They held four daylong meetings in which they went through each of the sites and agreed on the most important levers for revenue and profit growth in the local markets. Although the process may strike the target company as excessively intrusive, target managers will find there are a number of benefits to going along with it beyond pleasing a potential acquirer. Even if the deal with Cinven had fallen apart, Odeon would have emerged from the deal's due diligence process with a much better understanding of its own economics.

Of course, no matter how friendly the approach, many targets will be prickly. The company may have something to hide. Or the target's managers may just want to retain their independence; people who believe that knowledge is power naturally like to hold on to that knowledge. But innocent or not, a target's hesitancy or outright hostility during due diligence is a sign that a deal's value will be more difficult to realize than originally expected. As Joe Trustey, managing partner of private equity firm Summit Partners, says: "We walk away from a target whose management is uncooperative in due diligence. For us, that's a deal

Slainte

Gordon

leadership development you need it and your staff needs it

Dan Tobin succinctly made the case why so much well-intending leadership development falls short of the mark.

So what works?

Every couple of years, the HR consulting firm Hewitt Associates identifies twenty top "financially successful companies" that "consistently produce great leaders."

In identifying the 20 firms best at leadership development, researchers drew from 373 public and private companies in the United States in early 2005. The median revenue of participating companies was approximately $2 billion, with a median employee size of 7,300. Obviously, that's the big leagues. But the instructive lessons they provide can be applied universally to all types of organizations.

In summarizing Hewitt's Top Companies for Leaders research, the Wharton Leadership Digest notes:

Hewitt found that the top 20 companies differed from the other firms in several key practices.

1. The chief executive and board directors are more actively involved in leadership development initiatives.

Of the top 20 companies, 100% of the CEO are engaged, but of the other firms, 65%.

2. High-potential managers are more often identified, paid more, given greater development, and brought into more frequent contact with top executives.

Of the top 20, 95% identify high potential managers, but of the others, 77%.

3. Leadership development programs are more closely tied to compensation.

Of the top 20, 65% link explicitly leadership capacities to long-term incentive pay, but of others, 23%.

4. Company executives are held more accountable for leadership development programs.

Of the top 20, 80% hold management responsible for developing high-potential managers, but of others, 35%.

You can download a 20-page summary of Hewitt's findings (in a PDF file) here.

In a related "secrets of successful leadership development" item, David Parks of Bluepoint Leadership Development reveals the process Microsoft is using to develop its future leaders:

The Leadership Bench Initiative at Microsoft Corporation is a landmark example of a systemic approach to leadership development. In the course of a year, hand picked participants who are being groomed for director and executive roles are exposed to a series of workshops, action learning projects, and coaching.

Each experience builds upon the last and hangs together as a holistic leadership development process clearly linked to the business goals. It even ventures beyond the traditional boundaries of soft skill leadership development and incorporates financial and business modeling elements.

The entire experience is capped with a final session delivered by Microsoft executives who are involved in the process throughout.

Microsoft wasn't in Hewitt's Top 20 leadership development companies for 2005, but it looks like it's making good strides toward effective Leadership Development. (David Parks made his observations writing in his firm's The Point Newsletter this month.)

Now, if you've read this far, you're into Leadership Development—either as a provider, like me, who works with companies to grow their leaders, or you are in an organization striving to improve its leadership bench strength. One suggestion for anyone on the brink of launching—or assessing—a Leadership Development effort: Ask for the research basis of the programs and its models, assessments, exercises and all the (expensive and time-consuming) trappings that go into a leadership development undertaking.

Leadership Development is too often the province of guesswork and pet theories with little evidentiary foundation. Some good looking, well-presented and intuitively comfortable tactics not only are not proven to work, they are actually—when researched—negatively correlated with producing desired results. Ouch!

Question: Do you really want to subject the time, attention and energy of your most important human assets on what may be the psychological equivalent of snake oil?

Caveat emptor. Buenas fortuna.

Slainte

Gordon