Monday, June 20, 2005

Due Diligence

Due diligence is the integral part of any financial transaction, be that acquisition, merger or merely an investment. In fact, every time you invest in a stock, you should conduct basic due diligence process.

Due diligence is the process, fundamental to any investment. It is also a reality test -- whether the deal you are involved in is worth it. The person, actually several of them most of the time, conducts a thorough legal, financial and strategic investigation of the company's documents, operating history, contractual relationships and organizational structure. "Mergers and Acquisitions from A to Z" by Andrew J. Sherman (ISBN 081440376X) is a great source of the basics of the due diligence process.

The key to a successful deal ultimately lies with good due diligence process. The person should not conduct the process with the objective in mind. If you do, then you fail automatically. If you are looking for bad stuff -- you will find it. If you are looking for only good stuff -- you will neglect the bad one. Given a sufficiently large context one can find anything he/she wants. You can find a prophecy of Bill Clinton/Monica Lewinsky affair in the Bible if you try really hard!

It is not the task of the person who is doing the research to make a judgement. His purpose is to present all the information "plain vanilla", so that the dealmaker makes that judgement.

Here is a sample list of due diligence items one should be looking for:

Due Diligence Overview

I. Background / General
A. Brief review of organization and operating history
B. Provide a description of major products or services offered
C. Short-term and long-term operating strategy
D. Discuss vulnerability of the current strategy to the economic cycle, regulatory changes, variances in the Company’s competitive situation, and industry trends
E. Provide current business plan
F. Provide corporate organizational chart

II. Financial Performance
A. Audited financial statements (last 5 years)
B. Review of financial history by division (last 5 years)
C. Review of interim financial results by division
D. Quarterly financials (last 3 years)
E. Projected monthly budget by division (1 year)
F. Review of actual versus budgeted results (last 3 years)
G. Outline fixed versus variable expenses
H. Detail historical growth (visual aid)
I. Research & development expenditures (last 3 years)
J. Discuss seasonality of business and impact on working capital needs
K. Plans for future financing arrangements
L. Inventory analysis by product line

IV. Customers/Contracts/Programs/Products
A. Revenue and EBITDA/profit for major customers/contracts/programs/products (last 3 years)
B. Customer/contract/program/product concentrations
C. Total revenue for top 10 (last 3 years)Total EBITDA/margin for top 10 (last 3 years)
D. Major customers/contracts/programs/products gained or lost (last 3 years)
E. Discuss any contracts performing at a loss
F. Revenue by international vs. domestic
G. Discuss pricing dynamics and trends

V. Industry / Competition
A. Discuss current industry specific trends and how these trends affect the Company/programs
B. Discuss Company’s market share in each market segment
C. List primary competitors by division or market segment and their respective market share
D. List Company’s strengths, weaknesses, opportunities, and threats

VI. Marketing
A. Outline strategy for each product line or division
B. Outline sales/marketing coverage model
C. Current and historical market research/customer surveys

VII. Ownership Structure
A. Current ownership structure
B. Reasoning for current management’s desire to divest/sell the business
C. Share repurchase strategy

VIII. Management
A. Review any recent management changes
B. Overview of management stock ownership and incentive programs
C. Summary biographies of officers and directors

IX. Employees
A. Provide number of employees and if possible their functional breakdown
B. Outline incentive compensation
C. Discuss use of workers to address seasonal demand

X. Technology
A. Assess impact of technology changes on business
B. Discuss Company’s technology/engineering capabilities
C. Discuss current research & development programs
D. Review any material patents and/or trademarks currently held or pending

XI. Manufacturing
A. Describe manufacturing process for each product line
B. Describe present usage of facilities and equipment
C. Summary of quality assurance programs/procedures

XII. Suppliers
A. Discuss relationships with primary suppliers
B. Supplier volumes and degree of concentration
C. Total purchases from top 10 suppliers by product category (last 3 years)
D. Major suppliers gained or lost (last 3 years)
E. Discuss material prices, pricing dynamics, and trends

XIII. Accounting Methods
A. Summary of significant accounting policies (including industry specific nuances)
B. Discussion of internal accounting controls
C. Review any adjustments required for GAAP
D. Outline revenue recognition methodology
E. Outline pension funding policy

XIV. Other Items
A. Review of environmental issues