Authored Content by Michael Kidd
At Mowery & Schoenfeld, our team has been an active member in the Entrepreneurship Through Acquisition (ETA) community for more than a decade. Our methodology is one of partnership. We focus on providing thoughtful and efficient diligence services tailored to the unique aspects of these transactions. Our team helps guide many first-time searchers through the process both as an advisor and as a provider of key accounting support throughout the entire fund cycle.
On Friday, December 3rd, Michael Kidd—a consulting partner with Mowery & Schoenfeld and leader of the Transaction Advisory Services practice—presented “5 Pitfalls to Avoid During Diligence” at the Seventh Annual Harvard Business School Entrepreneurship Through Acquisition Conference. These insights were gathered from our work supporting over 250 ETA acquisition projects and are the most common areas we see an opportunity for a positive impact. The following summarizes this presentation for the benefit of our entire network.
Search Funds 101
For those unfamiliar, you may be asking yourself, “What is a Search Fund?” A search fund is an investment vehicle through which investors financially support an aspiring entrepreneur with limited capital resources. In simpler terms, it’s money to “fund” the “search” of a company to buy and run.
The entrepreneur, or “searcher," uses these invested funds to search for and acquire a company they can manage and grow, providing them a path for owning and building a business. The search fund model offers inexperienced but highly-educated and skilled individuals a path to managing a company where they can have an ownership position.
Pitfall #1: Overreliance on Outside Experts
Third party diligence adds subject matter expertise to your deal team, provides the benefit of prior experience and pattern recognition, and provides investors and lenders with an independent view on key items.
We see many buyers viewing 3rd party diligence as a fully-outsourced workstream. Buyers often dedicate limited oversight or input as they wait for the final output.
However, buyers can benefit from participating in the diligence process and incorporating the informal findings and signals gathered into their continual grading of the opportunity. Often this “soft” diligence can provide insights as important as those gleamed from data.
For example, if a target is unwilling or unable to provide certain datasets for financial diligence, you should incorporate that into your continued evaluation of the Seller’s trustworthiness and sentiment on completing the transaction.
Remember, the goal of the exclusivity period is to use both measurable and cultural diligence to create a wholistic picture of the target.
Pitfall #2: Improper Staging of 3rd Party Diligence
With the desire to quickly close a transaction some buyers will seek to immediately begin 3rd party diligence the moment the Letter of Intent (LOI) is signed, which also starts the clock on incurring costs to these providers.
We see a more successful approach by buyers conducting 1-2 weeks of business and commercial diligence prior to launching 3rd party diligence. This includes assessments related to:
- Market and competitive landscape
- Vendor relationship
- Growth opportunities
In the ETA community where the appetite and capacity for professional fees is limited these are all areas that can be explored independently and without incurring costs. If the business fundamentals are not in place, the results of financial diligence will be irrelevant. A better way to do this is to assess the deal-killer weighted risk as it relates to the potential outcomes of 3rd party diligence during commercial diligence.
Remember, the goal is to find a business capable of growth, which means looking at a wholistic picture of the environment.
Pitfall #3: Ignoring Post-Closing Implications of Findings
Another key source of critical information is the consideration of vital information gaps encountered during diligence. This could look like:
- A lack of timely responses to information requests
- An inability to provide financial updates during exclusivity
- Customer service complaints
- Out-of-date or frustrating systems
For example, if it takes the target 60 days to produce the financial statements after month-end, that is going to impact a 30-day reporting covenant stipulated by the lender after close.
Many entrepreneurs seemed caught off guard by how much time, energy, and capital they need to put into getting the house in order post-close before they ever get around to focusing on growth. Key to avoiding this from dramatically impacting the post-closing growth plans is to incorporate the information being gained from these interactions into the post-closing integration plan.
Remember, effective decision-making requires timely (and accurate) information.
Pitfall #4: Waiting to Negotiate Later
We routinely encounter breakdowns in process momentum caused by failing to define key points in the Letter of Intent (LOI) which creates fundamental misunderstandings between the buyer and seller over relatively minor items.
For example, based on their financial analysis, the buyer understands they may need approximately $100K in working capital at the time of close. But vague language in the letter of intent pushes this conversation until near closing. These late-stage negotiations over working capital requirements (which are typically minor points of value to the Seller in comparison to the broader transaction) are interpreted by the Seller as a purchase price renegotiation.
This can also appear as:
- Avoiding difficult conversations with the seller to get a company under LOI quickly
- Ambiguity about the relationship you will have with the seller post-close, including:
- Board participation
- Misunderstandings about working capital
We recommend working to get a functional understanding of all major deal points. Discuss working capital expectations in the Letter of Intent and again in the early stages of the purchase agreement negotiations to gain alignment with the seller about transaction structure early in the process.
Remember, your goal is to ensure close that is smooth and without (many) surprises.
Pitfall #5: Tunnel Vision on Closing the Deal
Be willing to walk away from the transaction—even in the final days.
A willingness to ignore difficulties and findings from diligence with the goal of closing the deal can have long-lasting problems for the buyer, the investors, and the business. The seller will always have a more complete understanding about the business than the buyer even up to the day of closing.
Therefore, it is critical to continually incorporate the information obtained during the diligence, as well as the reports and information coming from service providers, customers, employees, and your “gut feeling” into your continued assessment of the target.
Remember, the goal is to close a deal that will lead to growth and profitability for the investors.
Five Things You Can Do
In summary, there are five key takeaways for anyone looking to purchase (or invest in the purchase of) a company. Keeping these points top of mind during due diligence will ensure a smoother process for both the buyer and seller, and a higher likelihood of long-term success!
- Take an active role in diligence performed by service providers
- Stage service providers based on areas of risk / engaging prematurely
- Face the post-closing implications of challenges encountered during diligence
- Specifically define key points in the LOI to be negotiated later
- Always be willing to walk away if the deal is not right
Michael Kidd is a Consulting Partner with Mowery & Schoenfeld, LLC, where he leads the Transaction Advisory Services practice. In over a decade with the Firm, he has focused on providing assurance, planning, and advisory services to clients in a variety of industries. He has assisted more than 250 Search Funds and their entrepreneurs with various aspects of the fund lifecycle including fund compliance, conducting quality of earnings engagements, consulting on mergers and acquisitions, and working with the operating businesses after close.
Michael combines his analytical sensibility and curious nature to partner with clients. He strives to listen first and then present thoughtful, personal, and pragmatic advice. His goal is to see problems from the client’s perspective and provide insights behind the numbers.
In addition to their Transaction Advisory Services practice, Mowery & Schoenfeld is an active, dedicated supporter of the Search community, sponsoring ETA conferences and providing ongoing guidance to entrepreneurs. In 2021, Michael was named as a 40 Under 40 Professional by CPA Practice Advisor.
Michael holds a Bachelor of Science in Accountancy from the University of Illinois at Urbana-Champaign. He is a licensed CPA in the state of Illinois, a past chair of the CPA exam award task force and past member of the accounting principles committee of the Illinois CPA society.