Due Diligence Dance

Doing The Due Diligence Dance
By Stephen J. Kerr

Due diligence on an acquisition is a tough, time consuming and often high pressure job. It requires organization and persistence to complete. Basically, you are there to find out if the acquisition is a good deal for the company and uncover any flaws in their operations that could come back to haunt the acquiring company. The problem that most execs face is that there is not enough time and too little support from the buying company or the seller to do a good job. That is why so many acquisitions go awry after the sale. Due diligence is mostly completed after the deal has been struck to buy the company. The price and the terms are already agreed upon by the parties and you are there to verify what the seller represented in negotiations.

One of the worst due diligence performances I ever witnessed was done by Coopers & Lybrand, which sent out truly rookie accountants on a company and industry that they had no knowledge of whatsoever. Most of their "revelations" were standard practices in the publishing industry. And the truly important problems missed their scrutiny altogether. So, don't rely on hired accountants to do a job that industry professional are better suited for.

Most bad acquisitions are not a result of fraud, although you must always be on your vigil - they are a result of unrealistic expectations and oversight. The author/ producer contracts that could not be renewed, the distribution agreement that would not be extended, the acquisitions editor that was leaving after the sale, the foreign/movie rights deal that was "in-the-bag" (but wasn't). There are a million things that can go wrong with your acquisitions - but most can be prevented or lessened greatly by good due diligence.

The most important two senses that you can employ throughout due diligence are an eye for detail and a nose for deceit. The seller might not actually be trying to deceive you - but they start believing their own "bull" and want you to believe it too. By this point, the seller just wants his/her money and might tell you anything that will get the transaction closed.

Also, never think that you know more about this business than the seller does. That is how you can get into trouble. Every company and every owner has reasons for what they do. Be respectful and ask a lot of questions.

Here is a list of documents and due diligence questions for the purchase of a publishing or other intellectual property business that we use when evaluating a potential acquisition:

Accountant prepared audits or financial statements for the past 5 years.
Copies of corporate, sub-S or Schedule C tax returns for the past 5 years.
Monthly sales figures for the past 24 months.
Revenues broken down by source. Those revenue sources should include, but not be limited to subscriptions, advertising sales, listing sales, Internet, disk or CD-ROM, etc.. You should be able to get a schedule, tracking these revenue sources for the past 5 years.
Breakdowns by market, such as: direct sales to customers, trade bookstores, other retail, libraries, distributors, foreign rights income and special corporate sales or bulk orders.
This documentation should be broken down per book/video and compiled into one spreadsheet.
For subscription publications, you need a breakdown of customers. First/second/third year customers? Renewal rates? News stand sales? Etc.
Magazines/newsletters/journals: Subscription liability information.
Physical count of inventory? When was the last time that was done?
For controlled (free) publications like phone books or visitor guides - get breakdowns of distribution by city, county or state if they have it. Also, distribution by customer sources such as government, library, consumer and business.
Go over the marketing program in detail. What percentage of sales are derived from direct mail/telemarketing? How often are mailings done? How many subscribers/buyers are derived from out-bound telemarketing efforts? What is their success rate? How are these people compensated? Beware of companies who have been throwing more money at marketing with diminishing results.
What is their advertising sales program? How many people are engaged in advertising sales and how are they compensated? Get a sample of the rate card and ad count per publication? Do they discount aggressively off of their rate card? What territories do their salesmen cover and what could be done to improve ad sales.
For book publishers. Get the seller to provide you with title by title sales analysis and see if too much of the profit is being generate by relatively few books.
Get a history on the technological progression of the company. When did they make the step to integrated database management, CD-ROM and Internet. How has technology helped or hurt their organization and how are they coping with the changes?
Is their database in a proprietary format or a well know program? What other computer integration problems are you likely to have?
How many competitors do they have? Who are they and what do you know about them? Are there any new entrants into this market that you should know about? Are there any new Internet competitors vying for their same customers? What are the competitive challenges to the business now, and on the horizon?
Estimate the company's market share in their niche. Is this company growing by just keeping pace with the expansion in their markets or are they aggressively taking market share away from competitors? Estimate the size of their total market. Is it a growing segment or shrinking? Do you have good sources for industry data on which to make decisions?
Get copies of any distribution, foreign rights, sales or marketing contracts that are pertinent to their business.
Do they have a management chart? Get their last year's payroll accounting report. How are bonuses or commissions calculated and do they vary from year to year? List all employees by department. Are there any employment agreements between the company and key managers?
Is this company a sole proprietorship, limited-partnership, general partnership, sub-chapter S or C corporation? Public or privately held? When and where were they incorporated? Articles of incorporation? Has there been a corporate resolution passed authorizing the owner/manager to enter into negotiations to sell the company? Who has the authority to complete a transaction? Are there any other owners or outside parties who have a say in this sale?
Are there any loans or other commitments to employees or stockholders?
Get a list (and the addresses) of all part-owners and stockholders. In the case of a public company, all SEC filings and reports on this subject.
Get a list of strengths and weaknesses from the owner? What are the greatest challenges facing their company in the next 6 months? Next year? Next 5 years?

Make sure that you sit down and go through individual customer orders and payable invoices. Shuffling through those papers might tell you more about the true nature of the business than their accountant prepared financial statements will.

Do not be surprised if the owner does not have much of the documentation that we have requested in the forgoing list. Most smaller companies are run on intuition and habit. The worst offenders are often very profitable companies where the owner has not had to scrutinize his operations because he was always making money. Be prepared that you might have to jump into their general ledger for several days to extract out the information that you need.

Most of the problems that can come back to haunt you later were in plain sight while you were doing your due diligence. That is a warning not to be in a hurry or gloss over cracks in the company's foundation others say that they can "fix later". Often due diligence is done by middle management that doesn't want to tell the boss that he made a bad decision or is paying too much for the company. As a consultant, working for a company buying some publishing or film property - I have often felt the same pressure not to give Caesar the bad news that their winning bid is more for a salt mine than a diamond mine. My opinion has always been, "It's better to get bad news now, than a lawsuit later."

Doing the due diligence dance is not too far from the truth. You lead, the seller responds to your directions, and hopefully everyone will be friends tomorrow.