A thorough Due Diligence review is an extensive investigation of the seller’s business that a buyer undertakes prior to the execution of the purchase transaction. The goal of Due Diligence is to confirm as much as possible of what you think you know about the seller’s organization before you sign on the dotted line. The review can take many forms, from detailed legal, financial and operational examinations to assessment of the other agency’s culture for compatibility purposes. No matter what steps are performed, the mission is to carefully peel back the layers of the seller’s organization so the buyer knows exactly what they’re buying.
Initial discussions between firms considering a merger or acquisition of one party by the other are like dating: We all wear our nicest clothes, apply make-up or cologne, and do our best to avoid showing any blemishes. Yet, all of us have imperfections in one form or another. Whether an agency or its owners have experienced legal or tax problems, failed to document contingent liabilities, or just experiencing adverse revenue trends, Due Diligence is the means for uncovering these blemishes before moving ahead with the relationship.
Depending on your agency’s capabilities, your firm may be able to address some Due Diligence components internally. Without the skill or familiarity of analyzing another agency’s operations and finances, agency principals should consider the use of outside resources for this critical phase of the M&A process.
Let’s look now at the major components of the financial and operational aspects of a Due Diligence review. The legal and tax reviews should always be completed by your respective experts, internal or otherwise.
Asset vs. Stock Purchase Considerations
Purchase transactions between agencies can take two forms: as a stock purchase or as an asset purchase. A merger is simply a subset of a stock purchase, as are most internal ownership succession transactions. In a stock purchase transaction, the buyers acquire all of the known and unknown assets and liabilities of the seller when they acquire the stock of the firm. This means that any skeletons in the closet become the responsibility of the buyer. This financial exposure can be mitigated somewhat through contractual means, but it may never truly go away, and can disrupt or damage the reputation of the buyer’s organization.
An asset purchase, on the other hand, is a more defined shopping list of assets and liabilities to be acquired by the buyer. In an asset purchase, the buyer is primarily focused on the book of business, the core operating fixed assets and perhaps the cash, customer receivables and company payables. The rest of the balance sheet, as well as any unknown obligations or liabilities of the firm, remains with the sellers.
The Due Diligence for a stock purchase transaction should be substantially greater in scope than the review for an asset-purchase transaction. This is due to the significantly higher risk assumed by the buyer, particularly as it relates to the accuracy, validity and completeness of the entire balance sheet. This additional review occurs not only on the accounting or financial side, but should be part of the legal and tax review as well. Buyers must complete a thorough investigation of all potential unrecorded liabilities. They must also validate the accuracy of known liabilities and asset values before finalizing the purchase price and terms.
Due Diligence Procedures – Financial Review
Below is a description of the primary types of review to be included in a Due Diligence analysis performed for a typical asset-purchase transaction in which the buyer acquires the intangible assets (customer list), operating fixed assets and cash, premiums receivable and premiums payable.
The most important component of this Due Diligence review is usually the seller’s revenue, and should include the review and validation of:
- Supporting documentation of the premium and commission billing of the top accounts and other randomly selected accounts
- Revenue recognition of agency-billed items and identification of any collection problems
- Cash receipts and/or supporting billing information of direct-billed items (depending on the revenue recognition policy)
- Review of large accounts, lost accounts and new business to confirm the appropriate revenue is reflected in the Pro Forma.
A review of bank accounts, and in particular, the monitoring of the premium trust position and timeliness and thoroughness of bank reconciliations, needs to be part of any Due-Diligence engagement. Bank reconciliations are some of the most basic of all accounting controls, and are often an indication of the quality of the financial controls existing within the organization. Without meaningful bank reconciliations, the financial information presented by the seller may not be transparent.