WHAT AREAS DOES COMMERCIAL DUE DILIGENCE COVER?

Whilst traditional financial due diligence of recent trading performance has always been used as the basis of reviewing forecast trading performance and likely levels of sustained profitability, as in all investment decisions, past performance is not necessarily any guide to future performance. Therefore over recent years, in addition to financial and legal due diligence, increasingly purchasers are undertaking a far more commercially orientated due diligence designed to look at the strategic picture and the business’s competitive position within its sector and industry. As such it will be looking at trends within the economy, within the industry, and within the particular market in which the company operates, assessing the company’s mix of products and markets, its relationships with key customers and suppliers, its degree of competitive advantage or weakness, and the basis for its existing or potential competitive strategy; many of the areas covered by the business background and market elements of the sales pack discussed in Chapter 7.

In addition to being a vital part of building the purchaser’s confidence in your projections of the business, the internal aspects of commercial due diligence are becoming increasingly important for purchasers, as it is increasingly being recognised by purchasers that the success or failure of acquisitions usually depends on how well or poorly the purchaser is able to manage the merging of the acquired company’s culture and management into that of their existing organisation (known as post acquisition integration).

Research into acquisitions consistently suggests that the majority of acquisitions fail to deliver to the purchaser the value they were expecting to obtain and can therefore be regarded as failures. Further, the research goes on to suggest that in the majority of cases the reason for the ‘failure’ of the acquisition has nothing to do with the nature of the business being transacted by the target company or any problems crawling out of the numbers after the sale has gone through, but first and foremost is to do with people issues, culture clashes and failure to properly integrate the two businesses so as to achieve the envisaged greater whole.

Alongside the review of the strategic position of the business therefore, the purchaser will be conducting an internal review as to how efficiently the business operates, the quality of its decision making, management culture, and innovation and how these can be expected to integrate with those of the purchaser.

By spending some time during the due diligence process looking at the business’s existing structures, culture, and management style, the purchaser can get a much better feel for how they are going to approach dealing with the existing staff and management once the sale has gone through, and can therefore hope to get a much better result going forwards from the sale than otherwise (which will be of particular interest to you if you are on some form of earn-out agreement).

Commercial due diligence involves a review by the purchaser’s advisors of three main areas. These are:

• the strategic position: so as to give the purchaser comfort on the long-term prospects of the business
• the contractual position: so as to give the purchaser comfort as to the commerciality of the short term position; and increasingly importantly
• people.

COMMERCIAL AND CULTURE ISSUES CASE STUDY

The accountancy firm Deloitte Haskins & Sells had been founded in the UK in the 1850s by Mr Deloitte and had expanded over the years to become the international firm Deloitte Haskins & Sells, having teamed up with an American accountancy firm in the mid-twentieth century. By the late 1980s it was one of the ‘Big Eight’ groups of international accountants.

During 1988/89 the partners in the firm, led principally by the US, had decided that in order to remain competitive, they needed to merge with another firm. Driven by the US, the firm decided that its ideal partner was the firm Touche Ross. Discussions were held and eventually an announcement was made to staff that a worldwide merger with Touche Ross was to take place.

The problem with this was that it did not suit all the partners. Whilst the move may have made eminent sense for a variety of strategic reasons for partners in the US, for the partners in various other jurisdictions such as the UK, a local merger with Touche Ross looked distinctly unattractive. As a result, shortly after the announcement that there was to be a worldwide merger with Touche Ross, it became clear that the UK partnership decided it wished to merge with Coopers & Lybrand, a rival accountancy firm, and indeed a number of other local partnerships in other countries took the same view. After a lot of wrangling, the end results of the planned merger with Touche Ross was in fact the breakup of the international firm of Deloitte Haskins & Sells, with much of the firm led by the US merging with Touche Ross, and the bulk of the rest of the firm, led by the UK, merging with Coopers & Lybrand.

Then came the question of the name. Remember the Deloitte, in Deloitte Haskins & Sells had originally come from the UK firm, and not unnaturally the UK firm wished to keep this name in order to maintain its customers in the UK. Meanwhile the American side of the merger regarded the UK and other firms as simply breakaways from the main Deloitte Haskins & Sells business and therefore not entitled to take the name away with them. After a significant period of negotiation, the end result was that:

• Internationally the US firm that had merged with Touche Ross would have the rights to the Deloitte name. Internationally therefore, the new merged entity would be known as Deloitte Touche Tomatsu (where at the same time they had merged with a Japanese firm).
• In the UK however, the UK firm would retain rights to the name for a period of two years and the new merged entity in the UK would for two years be known as Coopers & Lybrand Deloitte. During this two years, the UK firm of Touche Ross which was of course part of the new international partnership Deloitte Touche Tomatsu, would not be allowed to use the name Deloitte and would therefore have to practise as DTT. At the end of two years, Coopers & Lybrand Deloitte would then change its name again, back to Coopers & Lybrand, at which point DTT would be allowed to become Deloitte & Touche in the UK.

I can testify from personal experience that during the first two to three years, and in some cases longer after the merger, much of the partners’ energies within the business were given over to internal turf wars over who was to emerge as head of which department, rather than getting out and growing the combined new business. This process carried on down the chain so that it was a good three to four years before members of staff who had come in from each of the preceding partnerships stopped referring to themselves as either ‘C siders or ‘D’ siders.

This was, I would remind you, the merger of two of the largest accountancy firms in the world, two firms who each provided strategic and corporate finance advice to numerous clients about how to handle business sales, purchases, mergers and post acquisition integration.

It is however a clear example of some of the features that commercial and other due diligence should be picking up to do with:

• Intellectual property rights. Who actually owned the Deloitte name?
• The strategic sense of the deal for all key staff. Was the proposal going to make sense for all partners and all national firms, and if not, how was the proposed merger planning to bind them in so that there would not be a risk of an embarrassing breakup?
• How were the two firms’ managements going to be integrated?
• How were staff going to be brought in to changing their ‘identities’ to thinking they were part of one firm?

STRATEGIC REVIEW

To assess the real future prospects of your business, the purchaser needs to understand:

• The big ‘external’ forces affecting your industry and business and what opportunities and threats arise from this by understanding:
  • What is happening in the business environment? (‘PEST’ analysis – see below).
  • What forces are shaping the structure of your industry and how much money can be made in it? (Industry structure or Porter’s Five Forces – see below).
• Your business’s ‘recipe’ and its strengths and weaknesses.
  • What products are you supplying into which markets and what potential growth strategies are there?
  • Where are your products in their lifecycles and have you got an appropriate portfolio of products?
  • What do your customers want?
  • What is your competitive advantage (based on what your customers want) within your industry on which you can build?
  • What is your unique selling proposition?

What trends affect your industry? (‘PEST’ analysis)

The world is a changing place. Developments across a range of factors will have an impact on your industry or business. So the purchaser’s advisors will be asking: ‘What are the major trends in the business environment in which you are operating that will affect your industry and business?’

There are five main headings that need to be considered for any industry, which can be summarised in a table as:

The purchaser will be looking to establishing how the impact of these factors is going to change your industry over the foreseeable future, and how your business needs to change to meet any threats arising (eg a need to invest) or opportunities opening up (eg new markets or an opportunity to sell the business).

How is your industry structured? (Porter’s Five Forces)

The attractiveness of any industry and the potential to make significant profits tend to be governed by the interaction of a number of forces. These will be analysed by asking you the five key questions as set out in Figure 10.

What products do you sell into which markets?

Your business will have a ‘portfolio’ of products and markets. The starting point for assessing the opportunities for future growth is by way of a product/market (‘Ansoff’) matrix as shown in Figure 11. This sets out a basic matrix for your business by asking two questions:

The due diligence team will then look to home in on each area to understand:

• What is the size of each product market box (segment) as a potential market?
• How much do you sell into this box (your ‘share’)?
• Is the market demand in that segment growing, steady or declining?

They will then explore the potential of the four basic growth strategies for any business which are then (in normal order of ease/risk):

• (i)Improving market penetration by boosting sales to your existing customers who already know you and your products:
  • Looking for the gaps – UK supermarkets (existing customers) are not taking any widgets (an existing product). Why not? What can be done to change this?
  • Increasing your share of a channel – do you supply 1%, 10% or 100% of small UK shops’ demand for widgets? How can your share of that customer/market’s spend on this type of product be increased?
• (ii)Developing new customers and markets for existing products, such as widgets (box X):
  • Can existing customers be persuaded to refer new customers to the company by incentivising them?
  • Can new types or groups of customers be identified who you can sell to? (eg business A might be a potential supplier to garage chains or overseas distributors.)
• (iii)Developing new products based on your existing core skills to sell to your existing customers to meet their other needs (box Y), particularly those of the acquiring company. Is there scope to add on a widget rental business, or becoming the UK licensee of the new Italian ‘Gadgetti’?
• (iv)Finally, and most risky of all, there is diversification (box Z) – the potential to develop a new product for supply to a new set of customers. This is regarded as highly risky because it involves developing a new product about which you have no knowledge, and selling it into a new market where you have little existing credibility as potential customers do not know you.

The acquirers will be looking to see how to achieve most from each of the above strategies, which will involve focusing on the most attractive product/market segments, which are those:

• with high growth
• where you make high profits
• where you have the most strength on which to grow.

Where are your products in their lifecycle and do you have an appropriate portfolio?

Individual products will have a lifecycle such as that in Figure 12 in which they either eventually fade away, are overtaken by newer products, or have to be reinvented. This process can take many years (the ocean liner) or be extremely fast (this year’s fashion).

New products tend to eat cash in development and marketing in order to grow their market share, before becoming established and generating surplus cash.

The Boston Consulting Group matrix (shown in Figure 13) is used to look at managing a portfolio of products (or businesses).

The purchaser will be looking to see where in the matrix your products are, you have an appropriate balanced portfolio of up and coming, as well as established, products, or are all the businesses establsihed cash cows or new question marks?

What do your customers want (critical success factors)?

There will be different things that are important to your customers in making their decisions about who to buy from.

• These are things that all potential suppliers must have/be able to do to be considered, known as order qualifiers – which airline will fly me from Heathrow to New York?
• And then there are things that decide which of the potential suppliers is actually chosen, or order winners, such as which airline will offer the best seats, food and frequent flier programme.

The purchaser’s advisors may ask management to rank the importance of these factors on a scale of 0–10 as Company A has done below, together with how management thinks (or better still if the information is available, how customers think) its own performance and its competitors’ performance rates.

The acquirer will be looking to see why these factors are important to your customers, and what needs customers are satisfying in buying from you. The purchaser is looking for comfort as to why customers want to buy your product at all. This is important as customers purchase to achieve benefits (of the ability to have a hole when they need one) rather than features (this drill is made of high speed steel). So to ensure that your business has a long-term future, buyers will want comfort that your marketing addresses how customers’ needs are met by your service (often emotional), not on its features (often technical).

What is your competitive advantage?

The long-term success that the purchaser is looking for relies on establishing and maintaining a ‘competitive advantage’ (A) over your present and future competitors. This can be quickly summarised as:

This means that you have a successful recipe for doing things

• better (B), cheaper (C) or differently (D) from your competitors;
• in a way that customers want (W)
• and know about (K),
• which competitors cannot copy (X – for Xerox), which overall makes money now (£N)- And then keeping it successful (so that it remains based on what customers want and is not copied). If you can demonstrate a strong recipe of this type as set out on a simple table such as the one below, this provides a compelling story to form the basis of the purchaser’s confidence in the long-term health of the business.

This sort of competitive advantage has to be underpinned by well developed business strengths in a variety of areas, the key ones being:

• Reputation – for many products it is often very difficult (eg from brain surgery to motor oil) to inspect the quality of the goods prior to purchase, so many customers will rely on brand names and reputation as a ‘safe choice’, even if this means paying a premium.
• Strategic assets – where investing in gaining dominance in a narrow niche (eg left-handed widgets) or in capital equipment, economies of scale, sewing up the key suppliers or distribution networks, know-how and improved skills from learning curve effects, can give a significant long-term advantage over competitors (and therefore certainty for the purchaser).

• The ability to successfully and commercially innovate and develop new and better ways of doing things or products and services can give you an advantage over your competitors (but you also need to be able to manage the risks associated with innovation and keep the key staff involved in innovation, and keep them committed to the business after the sale).
• Internal organisation and infrastructure – such as efficient stock and wastage control or internal communication which make you more efficient than your competitors.
• External networks can also help, such as joint venture and strategic alliances, or membership of a purchasing ring.

Do you have the right value chain?

What really makes your business worth buying is:

• what really makes your business different from any other in your industry (your unique selling proposition – USP), and
• that you have set up your business to really commit to delivering that proposition to customers (your value chain).

For a business set up to deliver ‘the lowest cost widget’, the purchaser will be looking to see that all aspects of your organisation and strategy are set up to deliver this to your customers as illustrated in Figure 16.

WHY CULTURE MATTERS

Case study

I was in involved in discussions over the potential merger of two mid-sized professional firms.

Firm A, based in the City of London, had a very plush, well appointed and neat reception area, with well tended plants and very tidy displays of corporate material. I was taken to meet the senior partner in his well appointed office, and everyone we passed in the corridors was wearing a smart, conservative business suit.

At firm B, a larger (and more profitable practice) based in the West End of London, with a reputation for handling an entrepreneurial client base, I waited in a decidedly scruffy metal-floored, mezzanine

reception area with magazines and papers scattered on the desk and a definite air that the cleaner was due in tomorrow for their weekly stint. Meanwhile staff in open-necked shirts came into reception to greet clients and I was eventually shown into a meeting room with boxes of records stacked in a corner and joined by the senior partner, dressed in chinos and a sports jacket and carrying a mug of coffee.

In many ways the commercial and geographical fits of the two organisations were very good. The truth was however, that due to the cultural differences between the firms, it was already apparent that any attempted merger stood little real chance of success.

Some of the strongest forces operating within your business are its culture and structure, but because they have grown up over time, have never been formally set out, and form such a pervasive background of ‘how we do things here’, the wood is often all but invisible to those working inside the business (including you), who only see trees. But they are vital to prospective purchasers as they are probably the key difference between a successful or failed acquisition.

Your business’s culture and structure are different but linked as shown below.

As businesses develop in size and complexity, the cultural style and the structure often develop along parallel lines from a power to role culture and from entrepreneurial to a functional structure.

Mapping the organisation

In reviewing your culture and organisation, the purchaser’s advisors will need to:

• Draw an organisation chart showing who formally reports to whom. How clearly structured is it? How logically organised is it?
• Review to what extent this ‘formal structure’ reflects the reality and the lines of power which relate to who goes to whom for decisions. Does this follow the ‘formal structure’? If not, why not? (For example, Fred is the factory manager, but all the lads on the shop floor still come to you as ‘the boss’ for all the decisions.)
• Everyone on the chart will need to be given a job title. Do they make sense given the lines drawn above?
• Check who is responsible for each of the key roles in your business (such as sales, marketing, customer services, purchasing, production, despatch, quality control, research and development, finance, personnel, overall strategic direction and drive).

Assessment of the management team

Having identified the key individuals, the purchaser will need to assess how strong the team is and how to ensure that those members of the team that are critical to the business’s future success are tied into the business.

Increasingly, psychometric tests form a key part of such management assessments and some useful psychometric tests can be ordered on line at www.turnaroundhelp.co.uk.

This work can be critical to the purchaser in planning their post acquisition integration strategy; their plan as to how they are going to manage the process following the sale, of integrating their newly acquired business into their own existing organisation and make any changes that they plan to make. An example of the areas such an assessment of management might want to cover is set out on the next page.