Episode 21 - Due Diligence
Episode 18 – International Tax Strategies and Forms provides insights for any US taxpayer with offshore interests, and any international person or expat with US interests. Jan begins the conversation with an interesting observation: “I think the perception is that Americans don’t realize that once they leave our shores and they move to another country or they obtain residency in another country, that they have foreign reporting issues (to the IRS). I think sometimes the term foreign reporting is interpreted to mean it’s not me because I’m an American citizen, when in fact if you are an American citizen outside of the states or you have foreign holdings, real estate, bank accounts, et cetera, outside of the United States, (filing an IRS tax return) does apply to you. And most people are quite surprised by that.”
The episode goes on to discuss various foreign investments, entities and real estate ownership as well as oft used IRS tax forms such as the 5471, 8858, FBAR (Form 114) and 8938. Jan goes on to explain the importance of transactional planning as it relates to international and US tax exposure with two simple goals: minimize tax exposure while protecting and preserving the associated assets.
Jan
Welcome to AB Cast, integrating Legal Tax Accounting and Business Solutions. I’m Janathan Allen. This episode is about due diligence.
Neil
Jan, due diligence is such an important part of corporate life transactions, even personal finances. In your mind, due diligence is one of those vague topics for many people. How would you define due diligence?
Jan
Due diligence is really a process. So when we speak of due diligence, particularly in the M & A or mergers and acquisition area, really what it is a process and a review of financial tax and corporate governance documents in order to verify the veracity of what the buyer is selling is telling the other party as it relates to a potential acquisition of an asset or the shares of a company.
Neil
So in essence, what’s the value of and purpose of due diligence?
Jan
Due diligence becomes really the test as to whether or not a company will move forward with the transaction. And what most people are looking through the process of due diligence is to verify what it is that they believe to be true about the asset or the company that they’re acquiring. So for example, if I were to say to someone, this is what my EBITDA was, and I produce financial statements that show something different, then the due diligence process allows the acquirer to verify the veracity of what they’re being told by the seller.
Neil
Jan, according to the Harvard Business Review, between 70 to 90% of business acquisitions fail after the transaction is completed. That’s an astounding number. What role do you think the failure or inadequate due diligence plays in that amazing statistic?
Jan
I’m not sure that due diligence really plays a factor. When you look at acquisitions, most acquisitions fail because when you converge or take over the assets of one company, there’s generally a culture that’s associated with the acquisition of those assets. And it’s really the conflict between the two entities and how it is that they do business and their perspectives and the value that they place on varying estimates. In terms of the business that really creates the conflict, it can be personnel as well, lack of common goals, lack of common shared values. I don’t think it’s really the due diligence process that fails. I think it’s the people part of the process that fails.
Neil
Fascinating. So Jan, when we’re approaching a transaction, what are some of the elements that go into an effective due diligence process?
Jan
The due diligence process is generally broken into three components, and the first would be the legal or the organizational and corporate governance component. And that’s where you go back and you review how the company was organized, have they maintained their filing updates with Secretary of States, et cetera. The second component is a financial review, and that is a fairly all-encompassing component of the due diligence process because it’s the most, it can be one of the most complex. The third would be, and it’s associated with the financials, is the tax component and how it is that taxes are going to effectively impact how it is the due diligence or the merger and acquisition is actually accomplished and what it’s going to cost. And then finally, there’s really the overall review of the market and into what the merger and acquisition may be going into. So what are the externalities and the external pressures that may impact any particular merger and acquisition that is really unrelated to the review of the asset or the stock of the company itself.
Neil
Jan, there’s so much to comprehend, to verify, to research after your decades of experience in these transactions. How do you keep it all straight and how do you make sure that you’ve attended to every detail?
Jan
Well, as I’ve indicated earlier, it really is a process, and that process is really monitored by the utilization of checklists. So when I go through a due diligence process and I send the information that I’m looking for, for example, from a seller, it can be three to four pages long. And again, it’s broken into component pieces, but there are checklists to ensure that you’ve gone back and you’ve reviewed very specific elements within each one of the components that you’re reviewing.
Neil
Got it. So one of the important things for a buyer to do is to verify the representations and disclosures of the seller. And sometimes inverse. What is that process like? And what are you really looking for there?
Jan
You’re looking for the veracity of what it is that you’re being told. I’ve seen a lot of pitch decks. I’ve seen a lot of proformas. I’ve seen a lot of information that’s exchanged when people first start talking about a merger and or acquisition. And when you go through the process, really what you’re doing is you’re looking to see if what it is that you’re being told is accurate, because there’s lots of ways to express something. And what I mean by that is having taught accounting, I’m always fascinated when I have students that come up to me and say, accounting is black and white. And quite frankly, nothing really could be further from the truth. Accounting is a methodology, for example, to classify financial information in a certain way. But just as that classification can be modified, the outcome of the financial statement is then modified based on what’s occurring and how the classifications occur within the financial statement.
So it’s important that when someone says, this is what my financial statements say, and you presume that they’re accurate, are they speaking on whether or not the financial statements are in a cash or an accrual basis? Is it a modified accrual basis? Has there been an association or a reconciliation done between book and tax? Because oftentimes people will get a financial statement and it won’t match the tax return because while tax is based on GAAP accounting, the modifications that occur in tax can lead to a totally different, for example, p and L number than you would see in a financial statement. So the due diligence process really leads us down the path to ensure that what it is that’s being represented by the sellers in any particular transaction are indeed accurate.
Neil
And the breadth and the accuracy of the information that’s being captured and thereby reported through the accounting process that’s going to wide verily from company to company. Is it not?
Jan
Of course. And it depends on the size of the companies. It depends on the sophistication of the individuals that are maintaining the financials. And I think one of the chief issues that occur in an M & A and why M & A deals fail before completion is because a seller doesn’t go through and prepare themselves for the due diligence process to go back and ensure that the information that’s being given to a prospective seller is accurate. And I’ve taken on a client that we started down this mergers and acquisition process this week, and they’ve come to us because initially they’ve gone through this process with others and themselves before. And one of the first things, one of the first comments of this client to me was, yes, we’ve learned that we had to go back and clean up our financial information before we actually gave it to a prospective seller. And so the due diligence process really begins before there’s a formalized offer to purchase. It really begins with the cleanup of the company and ensuring that the i’s are dotted and the T’s are crossed.
Neil
And what’s the impact of that on the value of the asset in question?
Jan
Well, it can impact value greatly. If you have financial statements that are not accurate or that misrepresent the financial accuracy of a company, that can have a huge impact on the valuation of a company, and particularly for an outside company that perhaps comes in and does the evaluation. So the underlying critical components of any business, the accounting, the tax, the processes, all that becomes part and parcel of the overall valuation of the company that is then impacted by a potential appraisal.
Neil
Jan, I’ve known you for several years and you’ve often talked about how people get stuck on one portion of a transaction, for example. What’s this going to cost versus thinking about what is this process going to save me or make me? And I think this is a perfect example of that. Don’t you think that going through the process of preparation inherently increases the value of the asset that you’re acquiring or selling? Correct?
Jan
Absolutely. The question that I’m often asked is, well, if I go through this preparation and we go through the due diligence process and we go through a dry run, what’s it going to cost me? And people are always, and rightfully so concerned about fees. But by the same token, if you haven’t gone through the due diligence pre play and it leads to an interaction with a potential seller, where that fails, then what is it that you’ve lost? And how much time have you lost because you as the seller, were not prepared to get through the due diligence process itself.
Neil
Jan, one of the main steps is a thorough analysis of the books and the financials. How does that fit into due diligence and what level of insight do most business people bring to that aspect of a transaction?
Jan
I think most individuals or businesses that are looking to do a merger and acquisition really don’t understand the scrutiny that the financial statements that they’ve been utilizing to run their business will be scrutinized. And there’s various differing types of analysis that can go back and be completed just based on financial statements and transactional reports coming from financial statements. It’s interesting to me that most business owners that I know are not terribly good at really understanding the financial statements that they utilize in their day-to-day planning for their own businesses, and the amount of information that can be gleaned simply by a review and a thorough understanding of what’s happening within the transactional reports in a financial statement. So for us as a service provider, it’s important that when we review the financial statements of a client in preparation for M & A, is the explanation of how someone in the outside world may view the financial statements that they have been using in order to complete the elements of their business transactions.
Neil
Jan, you also mentioned corporate governance and compliance. What role does that play in the process of due diligence?
Jan
Corporate governance and compliance is probably one of the most important, and it is regardless of whether or not someone is going through an M & A transaction, corporate governance and the finalization and the completion of the corporate governance documents and the reporting that is required on a yearly basis is critical. In the event of litigation, for example, against a company, the first thing that an attorney will go back and request are the corporate documents, the bylaws, the operating agreement, the cap tables, the ledgers of ownership, the minutes of members, the minutes of the board of directors, the minutes of the shareholders, because it gives a fairly complete picture of what it is that the entity’s been doing. When that is incomplete or non-existent, it really goes to show the lack of professionalism for the owners of the entity, the lack of professionalism in the entity itself, which really in and of itself is a harbinger of something to look out for because if this is incomplete, what else has been left undone?
Neil
We often talk about verifying not only the existing financials, but the sales, the customers, the employees, the key personnel if you will, and the market as well. What are some of those issues when you’re managing the process of due diligence?
Jan
Due diligence, we’ll go back and in, depending on the type of transaction, of course, we’ll look at the sales of the company and what the sales analysis is doing is looking for stability and upward trending. So for example, one of the questions that may be asked is, how many customers do you have? And they’ll ask for a ranking of the customers, who’s your most profitable customer to the least profitable customer? And then there’s a trending that looks as to how it is that the sales or those customers have been evolving or dropping off over a period of time. So generally, due diligence is not specific to one year. It generally covers a timeline, generally three years. And from the analysis that occurs within the due diligence process, one can get a better handle on where it is the company is really tracking to in terms of sales and its ongoing profitability.
Neil
And another key aspect of making sure that you’re getting what you think and that it’s going to continue the goodwill of the business is going to continue after the acquisition. How do you think about things like key personnel, the owners of the company who may need to work through a transition period? What are some of the things in your mind as you’re looking at that aspect of the transaction?
Jan
It’s funny, in the conversation that I had yesterday I was on with the potential acquirers of my client. One of the things that we discussed was what was it and what impact would this acquisition have on key personnel and how does it go back and impact them in terms of what’s being told to them prior to the acquisition and after the acquisition. Key personnel in any organization can really make or break the organization and really drive the success or the failure of a potential acquisition because of the native knowledge, I think is probably the best way to put it, that these individuals have within the organization that’s being acquired. So in terms of personnel, key personnel and the stability and the ongoing success of the company, the items that are related to individuals and the owners themselves are critically important.
Neil
Are there strategies for set asides or holdovers some form of we’re going to set aside some percentage of the acquisition cost so that if there’s a surprise or if things aren’t quite holding up to what you were told before, you can offset that?
Jan
Well, there’s lots of different ways to structure an M & A deal, and I think what you’re getting at are holdbacks or earnouts. So you go into a transaction feeling that this is the way that things will unfold, and in the event that they’re more successful, then, for example, if there’s a holdback, then the holdback is released, or if there’s an earnout, the earnout is released. On the other hand, if it’s not as successful as anticipated, then the holdouts are held out for a longer period of time and the earnouts become small or even non-existence again, depending on the efficacy of the transactions and the ongoing financial performance of the company.
Neil
Finally, you’ve got to check out existing known liabilities as well as contingent liabilities. How do we do that?
Jan
Well, one of the key fascinating things about due diligence is everybody’s on the lookout for liabilities that are really not recorded. So for example, one of the things that people always ask, and in the due diligence process in the legal portion of the substantive area, is you always ask whether or not someone has been subjected or feels that they may be subjected to a lawsuit because a lawsuit isn’t recorded on a financial statement anywhere, unless of course, the entity is within a potential lawsuit and is recording legal fees. But that doesn’t mean that there couldn’t be a liability that comes down the line because of a threatened lawsuit, either from personnel or from a customer or from an outside source that is unknown. So one of the key components of the review of the financial statement is to ascertain whether or not there are any unrecorded liabilities that could impact the future financial viability of the entity.
Neil
Jan, these transactions, the buyer has their interests, the seller has a separate set of interests, and in some ways they are aligned. So can you talk a little bit about the interest from the perspective of the buyer and the seller, and then how they work with each other and then often against each other?
Jan
Well, I think the interesting thing about looking at buyers and sellers is I think they have more in common than they normally believe. The buyer wants to get a deal on what it is that they’re purchasing. The seller, of course, wants to maximize what it is that he’s selling the company or the stock or the membership in the companies for. So to that extent, there can be some tension, but at the end of the day, the actual synergy between the buyer and seller is quite the same. Both are looking to maximize their efficacy in the financial acquisition to the benefit of each other.
Neil
Jan, I think the biased perception of most sellers would be, I want to get my money, get on with it and get onto my next venture. Is there a value to having the seller remain involved in the business after the transaction? And how often does that really play out? And in your mind, what are the key issues there?
Jan
Again, it depends on the structuring of the deal and the transactions. So I’ve seen it go both ways. I’ve seen asset acquisitions where an acquirer will come in, purchase the assets of a company and not really want anything to do with the owners. By the same token, oftentimes the owners have built a business, they want to cash in on what it is that they’ve built, and they don’t want anything more to do with it. I think the way that a lot of transactions might be more successful is instead of taking a look at this as the first bite of the apple and selling a company is staying on with a new company and potentially looking at an additional transaction downstream, that will be, again, the sale of the company, but on a much larger scale. And I see a lot of transactions where initial acquisition is only the start of a chain of transactions leading ultimately to a liquidity event where the owners of the original business really get a much larger payout if they stay on during the interim.
Neil
Due diligence crosses the boundaries of many different disciplines. Alan uniquely positioned to advise clients and manage multiple aspects of the process of due diligence across legal, tax and accounting issues.
Jan
That’s correct, and that’s the way that the firm has been structured for all of these years. We’re really a platform that provides these accounting, tax and legal services in an integrative manner that other firms can’t and don’t provide because of the singularity of the type of practice that they may have.
Neil
And Jan, I would think in an acquisition, that is almost impossible to overstate because if you just have someone who’s looking at it from a tax perspective, they’re not considering the other implications and how that affects the transaction as a whole, versus if you have someone who can integrate it and say, look, from a legal perspective, this is the advantage, but from a tax perspective, we really need to think about these two issues, and therefore, from an accounting point of view, we need to be capturing this data. That seems like the intrinsic value of being able to blend the three to get to the real answer.
Jan
Well, I think it’s a matter of efficiency. You can accomplish all those things, but how many firms or how many people do you have to have involved? So if you have to hire an accounting firm and you have to hire a law firm, if you don’t have those particular areas in-house, then there’s three or four or five people sitting around the table instead of potentially just one.
Neil
Thank you, Jan.
Jan
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