There is no such thing as a perfect deal and there will always be pitfalls waiting for buyers as they go through the diligence process. The most common ones can be avoided, however, if buyers can pay attention to them in due time. Joined by Joe Beer, the VP of Operations at Sun Acquisitions, Domenic Rinaldi shares the top seven most common due diligence pitfalls that buyers encounter during M&A transactions. Having been involved in over 200 closing transactions, Joe is familiar with almost every aspect of diligence and closing a deal. This is by no means an exhaustive list of the pitfalls that buyers need to avoid, but it’s a good place to start.
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Joe Beer: Top 7 Pitfalls That Buyers Face During M&A Diligence – Ep. 087
Due diligence is fraught with all sorts of pitfalls for buyers. In this episode, I interviewed Joe Beer, who’s the VP of Operations of our firm, Sun Acquisitions. Joe has been with us for several years and has been involved in over 200 closing transactions. His role is to facilitate every deal once the buyer and the seller have agreed to a formal offer. He helps the parties during the diligence phase to deal with and manage through the inevitable speed bumps and keep the transaction moving towards the closing. As you can imagine, with that many deals under his belt, Joe has seen and done it all when it comes to diligence and closing a transaction. We uncover the top seven pitfalls that buyers face when conducting diligence. Whether you’re a buyer or seller, you will want to hear this list and know how to avoid these common pitfalls.
I promise you will walk away with an enhanced appreciation for what it takes to conduct diligence and consummated transactions. You wouldn’t want to miss this episode. Before we get into the episode, however, we’ve created a best practices and checklist for how to conduct diligence. This is a free resource available on either of our websites, SunAcquisitions.com or K2Adviser.com. Take a minute to download this invaluable resource. It’s a great starting point for you and your advisers when contemplating an acquisition. Thank you for being here and I hope you enjoy this episode.
Joe, welcome back to the show.
Thanks for having me, Domenic. I appreciate it.
For those in the M&A Unplugged audience that doesn’t know you and not familiar with you, you are the VP of operations for our M&A firm, Sun Acquisitions. You’ve been with us eight years and you have a critical role in our operation. You oversee every transaction. Once a buyer and a seller have agreed to an offer. You get involved before that in some of the negotiation and the LOI back and forth, but certainly once a deal is agreed, you then take over the deal and you run point from that point until the deal either closes or dies. Fortunately for us, you’re great at what you do. We close most of our deals. I’m curious, at this point, do you have a sense of how many deals you’ve been involved in?
I don’t have the actual number, but I’d say it’s approximately probably over 200 deals.
Lots of experience, you’ve seen and done it all across a broad range of industries. I’m excited to get the topic, which is the top of pitfalls. We came up with a list, you and I, of the top seven pitfalls that buyers hit when they look at doing diligence on a deal. I want to get into that and dive into these seven pitfalls so we can help people at least get educated and hopefully avoid making these mistakes. Before we do that, a quick backgrounder on yourself so folks know a little bit more about your educational background and why maybe you’re a great fit for this role in our firm.
I’m a licensed attorney. I practice for a little while before joining Sun Acquisitions. I always wanted to break into the M&A space. It’s a nontraditional way for an attorney to do that, but I’ve been doing it for several years now for my Sun. It’s been fantastic. The attorney background helps a lot. I don’t represent the buyer or the seller as an attorney, but having that background makes me fluent in all the conversations around purchase agreements especially in the later stages of the deal when we’re getting into some of the technicalities. It helps to have that training and background.
I think I’ll also mention too, while this is not your formal training, you grow up with a dad who owned his accounting firm. Numbers are not lost on you either. You bring a numbers background along with your legal background. It’s a great mix for people who need help during the diligence process and the closing process. You’re not anybody’s attorney in the transaction but you represent one side or the other based on who our client is. If we happen to re–represent the seller, you’re representing the seller or vice versa or the buyer, you’re representing the buyer. You facilitate that entire process between both parties so it’s important that you have a relationship and rapport on both sides.Time kills deals. Moving diligently and swiftly in a deliberate manner is crucially important to any M&A deal. Click To Tweet
Following up on the numbers thing, I think I took every class I could take in law school to catch up including accounting for lawyers, which I sometimes refer to as accounting for dum–dums. I did as much catching up and as I could in law school. I got my business law certificate there. I do have both those backgrounds.
Let’s go ahead and dive into these pitfalls because we’ve seen too many times buyers coming to the table with a deal in their hands and they fall suspect to some of these challenges that could have been avoided. We want to do our part to educate people. We’ve put this list together in no particular order, but I will say the first one on the list is probably the number one thing, which is the number one pitfall is people not choosing the right advisers. They come to the table and not having the right team behind them. Why don’t we start with what are the right advisers? When we use that term in M&A, terminology, what does that mean for people? How does that manifest itself in deals?
You want to make sure upfront and this advice applies to buyers and sellers to be honest. All the sellers reading out there can take note as well, you want to have the right team assembled well in advance of your planned acquisition mode. To me what that means is first and foremost, having a good accountant and having a good attorney. The term good is quite generic, but in my mind, you can break it down relatively simply to someone who has experienced in the sector that understands closely held companies, how they’re bought and sold and what finance documents look like. If there’s real estate, they need to have commercial real estate experience, whether it’s leasing or even if the property is up for sale, the owner–occupied property.
You want an attorney and an accountant who understands this market, how to look at closely held companies. You also want someone that is quite frankly, going to be responsive to you. They need to have the bandwidth. In this day and age, when everyone’s taking on more and more projects, it’s important that whoever you choose understands that they’re going to need to vote a portion of time to the deal and to get it done quickly. As I’m sure you’ve said many times on the show, time kills deals. Moving diligently and swiftly in a s deliberate manner is crucially important.
To put a bow on what you’re talking about here, mergers and acquisitions experience from your attorney and your accountant is critical. They’ll know the terminology. They’ll understand what’s happening in the current market because things change. You see changes to representations and warranties over time and indemnifications. During COVID, if you don’t have an attorney that is doing M&A deals, they’re not going to be conversant in what’s happening in this environment. There have been significant changes to agreements given what’s going on with the pandemic. You need people that understand mergers and acquisitions. Joe, I know there are probably a ton of examples. I won’t cite the specific one, but I remembered that a client came to us once and their attorney was going to be a litigator, somebody who litigated and didn’t spend a lot of time on M&A.
There are a couple of problems there. Number one, most litigators are in court every morning and half their day is shot in court. The other half, they’re scrambling to follow up on whatever happened in court. M&A becomes an afterthought and those clients get lost in the mix. As we stated, time kills deals. You need attorneys who are there and can respond very quickly. That’s not a knock against litigators. They may not be the best attorney for you to get an M&A transaction done.
The mentality is different. Litigation is a much different mentality than transactions are. There’s an inherent adversarial component to litigation. I think often people that spend a lot of time in court let that mentality bleed into the M&A practice and that can create some real stonewalls in getting deals done. The attorney’s job is to protect the client, but also to get a deal done. If you’re overly protective in that litigation mentality, it can cause the deal to suffer, stall or even die.
Hopefully, we got our point across there and it really is. We could spend the whole show talking about how to get the right advisers and why it’s so important because without the right advisers, you can make many mistakes. You can buy a business that you had no business buying. The advisers will keep you from making expensive mistakes that are hard to undo. Let’s go on to pitfall number two, which is you are failing to include all of the critical components in an LOI. We always say, Joe, you and I, and everybody in our firm, are good diligence starts with having a great LOI that has a lot of specifics in it so the parties, their attorneys and accountants don’t get lost. Let’s talk a bit about that. When we say critical components, what do we mean by that?
There is a fine line between going overboard, obviously. You’re getting bogged down because the LOI is a framework. You’re going to get to a purchase agreement phase, but you want to include enough detail that when you get the purchase agreement, you’re not stalled on issues that are unresolved. It comes down to price and terms. Price and structure of the purchase price, how much is being paid upfront? Is there a hold back? Is there a seller note? One thing that I see a lot of people tripped up is the details around hold back or the details around maybe the seller are going to hold a promissory note after the fact. That’s one of the biggest hangups I see in these deals is how long and if there’s a hold back, how much money is being held back? How long is it being held back for what kind of rights are there?
If there’s a seller note, is there a right of offset? How much is the note? Is there an interest rate? Is it secured? The list goes on and I find that it’s not necessarily priced per se, but it’s termed around the price. It’s easy to leave out any one of those aspects or get confused by them. When you have a seller note, as an example and there’s going to be a security interest, what does that mean? Is it security against a certain asset to the business? Are there outside assets that are being used to secure it? If there’s a shortfall, are there any personal guarantees being signed? Who are they being signed by? All of those components are critical and I find that the later stages are you’re caught up in details that maybe you couldn’t negotiate.
I could see that section that you were going through. People going back and reading to that over and over. There’s a ton there but there’s a ton that we didn’t talk about this. Again, this goes back to, you have to have great advisers to get you through these. Dates was something that you didn’t mention there, Joe, but let’s talk a little bit about dates and how that plays into a good LOI.
This applies for both buyers and sellers, but even for buyers, you want to set out timelines. You want to set out dates so that expectations are properly set in advance. The worst thing that can happen is you set unrealistic dates or you set no dates at all. You’re living in this no man’s land of this deal perpetuating on and on without any end in sight. It’s important not to set a closing date so that your seller sees some light at the end of the tunnel, but that you set some dates in between them so that you know, when is financing supposed to be completed? How many days do you have to complete your due diligence and things like that? You want to give yourself enough time, but you don’t want it to be so egregiously long that you have a seller sitting around waiting and getting anxious about whether the deal is going to close or not.
The quicker you can move, the more likely you are to reduce what we would call deal fatigue. That’s on both sides. The longer the deal drags out, you lose that love between the parties that they had when they first engaged one another. You’re starting to see a breakdown in the communication, the conversation. An issue that might’ve been nothing at all in terms of a confrontation, now at the end of 60, 90, 120 days, how far are you out into the transaction, it becomes a bigger deal. You start to see both parties digging their heels in where they otherwise wouldn’t.
Deal fatigue sets in, people get tired and the littlest things can set people off. You go back to the quality of the LOI can ensure the success of the transaction. Don’t overdo it, but make sure all the proper elements are in place so that you can get through diligence in an unencumbered way as quickly as possible. Meeting the deadlines and doing no harm the business because during discovery, there’s a lot that happens and you want to get through it quickly that the new owners can get into the business before any harm can happen to the business. I think those are all tremendous points. Let’s move on to pitfall number three, which is people not taking the right amount of time or the right approach to understanding the customer base. Let’s talk a bit about that and where the pitfalls are there.
When looking at the customer base, there’s a lot of metrics, but some of the most critical metrics are customer satisfaction with the services or products being provided. If there are any concentrations because one or two or three customers make up a very large percentage of the company’s overall sales. You’re going to want to look at things like retention and attrition over time. Are they adding new customers each year? Are they losing customers? This is one thing buyers might sometimes shy away from because sellers are naturally protective of their customer names. If they don’t have a serious buyer, they don’t want to be showing the customer names to everyone. That’s probably likely in most companies, one of their most valuable assets is their customer base across, their customer list, their goodwill, but that shouldn’t deter buyers from getting the information.
You can get a lot of that information, especially about concentration, retention, attrition and things like that by filling in a customer ID number and anonymizing the spreadsheet. If you have a sophisticated enough seller, they’re going to be able to provide those reports in a redacted format at least early on. In the later stages of due diligence, when a buyer’s proven that they’re committed to getting the deal done and maybe they have financing locked up, then you’re going to probably get into that customer satisfaction realm.
With big and private equity firms, you see a lot of the hiring professional outside services firms to do anonymous customer surveys. It’s common nowadays to be getting emails or phone calls about customer satisfaction. I don’t think a lot of people think twice about it. It could be something as simple as a do-it–yourself online survey. You can create it and have the seller send it out from them. It’s not even from the buyer or even from a third-party, but the seller sends it out. We’ve seen great results with those types of activities where it can give the buyer assurance that there are no issues lurking around the corner. If there are issues, that they can be addressed may be ahead of time and discuss with the seller as a post integration plan.No deal is perfect. Buyers need to have a healthy degree of both skepticism and flexibility to minimize pitfalls as much as possible. Click To Tweet
I love the tools that you mentioned because if you’re a buyer, please understand that sellers don’t want you talking to clients and signaling that there’s a sale in the process. Because if the deal doesn’t go through, the seller wants to make sure they’re maintaining their clients. You, as a buyer, don’t want to let anybody get a sense that maybe the business is going to be transacted because those clients might start looking for another provider if they feel uncomfortable. The way to get around that is through Joe, what you were mentioning, these surveys so that nobody has to know that there’s a transaction pending, but a buyer can still get comfortable that the client base is satisfied with the services and the products that they’re receiving. It’s something that buyers don’t do enough of and should be doing more of.
The last thing I’ll mention about this category, as far as clients go is, what does it cost to acquire a new client? That’s something that a lot of buyers don’t dig into in diligence, but it’s important because you need to understand how much money has to get spent in marketing and sales to generate new clients. If the cost of acquisition is high, then you need to take a step back and understand what that model looks like for you. These are all pitfalls and buyers don’t spend enough time here digging in and understanding this piece. Let’s go on to the next pitfall, which is missing details or compliance issues. There’s so much here. The list goes on and on especially depending on what industry a particular business is in. Let’s dive into what you mean by compliance and some of the details.
When you’re entrenched in financial due diligence or getting lease assignments, working through a purchase agreement and all the other renegotiations, it’s easy to miss some of these little details. These are the little things like UCC searches. Most people are doing UCC searches to see if there are any liens against the business. That could be private liens, that could be tax liens or that could be judgments against the business. You want to make sure that you do a UCC search far enough in advance that if there were a lien to show up, that you have enough time to resolve it. We’re dealing with the deal as we speak where a lien popped up and there was confusion over what assets were being secured by that loan.
They thought it was one host of assets and it wound up being another. We lost two weeks on it not knowing. If we had done the searches a little earlier, I should say in that case, the bank or the person financing had done it a lot earlier, we’d have that in place. We would have been able to address it a little sooner. That’s one example. If the state you’re in requires any tax clearance, here in Illinois it’s called a bulk sales clearance and it’s required by the Illinois Department of Revenue and the Illinois Department of Employment Security, you want to get those tax clearances like the UCC searches done well in advance. A lot of times there’s a hold back needed where there are some taxes owed or some states do it where they make a projection based on how much tax they think would be owed even if there is none owed. You have to hold that back.
Not only do you have to hold that money back, you got to get an escrow agreement put together and determine who’s going to be the escrow agent. It’s not as simple as, “We’ll set aside a pool of money.” There’s real administration involved in all of that. Those are two of the bigger ones, but you should also make sure, does the business needs any license or permits to operate? Because that can take time and even with COVID going on, we’ve seen that it can take even longer. Governments aren’t working as quickly. We had a license in Chicago actually on a deal. It took months and months because it happened to be right at the height of all this going on in March and April in 2020. It was a very lengthy period. There’s probably a million more I can mention.
The two that comes to mind to me are unions and pensions and 401(k)s. Sometimes the issues related to transferring those relationships over are so substantial. You could easily be adding 60, 90, 120 days to the process. You want to get on those things very early in the process. As early as possible so that it lines up with potentially when you’re going to be closing the deal. There’s a delicate point here because you don’t want to contact folks that do those things too early, at the same time, you don’t want to wait until the last minute because then that could put the deal on pause. We’ve seen that happen.
When that happens, you open the door to all sorts of bad things. The business could go into decline. A long time ago, we had a business that burned to the ground because it came to a halt while all this work was going on and there was no business to be sold. There are substantial things that can happen when you introduce delays like that. You want to make sure you understand all those compliance issues in those details and you’re addressing them at the appropriate time during diligence.
We don’t have to go too far into it, but if you have customer contracts or vendor contracts, you should be paying attention to what the requirements are. If there’s assignability, if notice is required and if so, how much.
You’re getting into our next pitfall, which is contract assignability. The fifth pitfall here around understanding contracts. Let’s talk a bit about why this is a pitfall for buyers and what they need to be thinking about.
When you’re looking at situations where there are material customer contracts or vendor agreements, there’s a lot to look at in these contracts but the main thing, the gating issue is, can the buyer takeover this contract? Are they allowed to take over this contract? What they need to look at specifically is whether it’s assignable. There are three things. It could say that you can’t assign it without consent. You need to go get the consent. It could say, it’s freely assignable, which if you get lucky, maybe once in a while to get one of those or it’s silent on the matter, which is attorneys might argue differently. Some would say that there’s a presumption that you can assign it if it doesn’t specifically prohibit it though, there’s going to be some angst probably there in making that assumption.
You want to look at whether or not it’s assignable. If it is assignable, what’s required and how much notice do you need to give because you’re going to back that into your closing date. If 30, 60, 90 days in advance are required to giving notice to this vendor or customer, you’re looking at a lengthy period. You want to be cognizant of those things as a buyer and you want to make sure that you get copies of the customer contracts and vendor, the ones that matter. The material customer contracts and vendor agreements.
Also, understanding changes of control. It might not even be assignability. There could be control clauses in a lot of these contracts that even though they can be assigned, if there’s a change of control, it triggers a review or an approval process.
We had one of these where there was a buyer that was very interested and one of the main reasons they were purchasing the business was for a vendor relationship. It wasn’t even a customer contact. We stalled out a little bit at the end because it happened that the person that makes the decisions about whether or not this would be transferred was out on a health emergency. You want to have a plan in place to understand or even go a step further of who am I going to need to talk to get this transferred.
We’ll put a bow on that one and wrap it and go to the next one, pitfall number six, which is understanding the timelines to close and why that’s so important. Buyers have been caught not paying attention to timelines and all of a sudden, their deal is in jeopardy. Let’s talk a bit about that.
We touched on it with the LOI. You’re going to want to create a nice roadmap and a timeline. Setting the expectations ahead of time and making sure that as a buyer, that you’re not, for example, losing exclusivity if you’ve taken too long to get to whatever milestone or even to get to the finish line. Most sophisticated sellers, if they have a good representative are going to have some guardrails baked into the letter of intent that says that the buyer needs to be meeting certain milestones to maintain exclusivity or in some instances, the exclusivity expires. It doesn’t go on ad infinitum. You have 60 days or 90 days.
It’s important that you set a realistic timeline to maintain exclusivity. It’s the respectful and polite thing to do for your seller. If there’s going to be a delay or if you know that financing is going to take longer in a particular instance, depending on how you’re financing the deal. If you let your seller know those things upfront, then when it happens, there are no surprises. They don’t feel like you’re trying to hide something from them.
Timeframes are in there for a reason. They’re in there to make sure that the deal moves at a healthy pace. Nobody wants to jam a deal through at the expense of somebody making a mistake. Nobody wants the litigation after the fact. Everybody wants there to be a good transaction, but having a healthy pace matters because from a seller’s perspective, if you as a buyer get into diligence and decide at some point that this isn’t the right deal for you, they may have buyer number two and buyer number three in the mix. Being respectful of that is important. The other thing that could happen is delay and miss targets. If you get to the point where your timeframes are up and now you have to ask for an extension. If you haven’t been thinking about meeting those early dates, a seller might not be willing to do an extension or even if they do an extension, they might not be willing to do it with exclusivity.
Now, you’ve lost the exclusive right to do that deal. Don’t fall into that pitfall set. Set realistic timeframes that you think you can hit, work along a decent timeline and get your advisers involved. If hiccups happen and speed bumps happen, if you’ve built up goodwill, you can get extensions. Don’t drag your feet early on. You could wind up losing the deal if any of those things lapse. We are wrapping to number seven and this is a big issue. It comes up time and time again, where buyers either don’t understand work in process and working capital needs or they completely underestimated or they don’t have the right advisers to help them understand it. This is a big pitfall, understanding work in process and working capital needs.
This comes down to what’s included in the sale and whether or not it’s going to be prorated or if there are floors and ceilings to this stuff. When it comes to work in processes as an example, how are you going to look at the work in process? Are you going to prorate it based on a percentage of completion and have the buyer take it over from there? Does the seller get reimbursed for their costs? They’re going to have time and materials into some of these jobs. Not every business has work in the process, but the ones that do, the seller is going to at the very least expect to be reimbursed for the time and materials they’ve put into it already.
It would be a windfall to a buyer if that did not happen. That’s not the only way to do it. You certainly can have instances where it’s prorated based on a percentage to completion. You want to set that expectation upfront. Going back to the LOI stage, we see this one gets missed time and time again or willfully missed. Some people want to kick the can down the road. I’ve seen situations where we try to include it and some attorney or even the buyer or seller strikes it out completely. It’s a recipe for disaster because you can be talking about real dollars here, depending on the nature of the business. It can have a real swing in the overall enterprise value being sold.
It drives right into, what’s the working capital needs of that business on a go-forward basis. If you haven’t contemplated walking into the work in process and you’re going to leave that all on the table for the seller, then you have to have a probably pretty substantial amount of working capital on day one, which might not make sense. Something that buyers don’t spend enough time with and I will say that they also don’t understand that in small businesses, many of the financial statements and we’re going to talk largely about the balance sheets here because these aren’t the internal statements. This is balance sheet stuff there.
A lot of times they’re not GAAP-compliant and they’re not reviewed. These are simply compiled by the seller and it requires some real diligence. Digging in and understanding what’s there. Does the seller take deposits for their product or service? Are they holding those deposits as a liability on the balance sheet properly? All those sorts of things play into understanding what you’re walking into and getting day one. If you don’t give this enough time and effort, Joe, your point about the actual purchase price of the business might get inflated substantially if you miss this piece. It comes back to do a great LOI, get great advisers on your team and you’ll avoid a lot of these pitfalls.
On this topic alone, it’s so complicated. We could talk forever about working capital and what’s included. Is there a target? Is there a post-closing adjustment? What does that look like? How much time do you need? You could go on and on. We could do a whole episode about prepaid working capital and work in process because it’s a complicated issue. I think a lot of people either underestimate it or fail to account for it entirely in some ways.
This has been great. This is an awesome list. I will say these are not the only pitfalls. There’s a laundry list of other pitfalls, but we wanted to bring out the top seven. The things that we see happen, very often but there’s still a ton more that needs to be contemplated. As we wrap up, any closing thoughts that you would have.
My best closing thought for buyers out there is to have a healthy degree of skepticism, but also a healthy degree of flexibility. No deal is perfect. While there are going to be pitfalls that you don’t can’t account for or don’t know about, you can’t catch them all. You try to minimize them as much as possible. I think some buyers might get stressed out that they have to unturn every stone or figure out every single thing and it’s impossible. There’s not enough time in the day to do that. I think you have to balance some skepticism with some flexibility when you’re performing your due diligence and focus on the things that matter or it’s going to be very challenging for you to get a deal done.
It’s an awesome discussion. For the folks in the M&A Unplugged community, we have developed a due diligence framework, best practices and checklists. It’s available on our website. Please go ahead and download those checklists. I think it’s important to get those as a starting point. Joe, I appreciate you being here. This was a great conversation. Thank you so much.
Thanks for having me on, Domenic.
If you enjoy our content, please remember to subscribe and review our show. I look forward to seeing you again on the next episode and until then, please remember that scaling, acquiring or selling a business takes time, preparation and the proper knowledge.
About Joseph Beer
Joseph Beer joined Sun Acquisitions in 2013 after working for a mid-sized law firm focusing on banking and financial services and corporate transactions. As Vice President of Operations, Joe is responsible for managing all aspects of the business transactions process.
Joe works closely with buyers and sellers as well as their accountants, attorneys and lenders to help ensure that deals make it to the closing table as timely and efficiently as possible.
Joe’s organizational skills and attention to detail have helped him close numerous deals in a variety of industries. Joe has vast experience negotiating contracts including purchase agreements and commercial leases.
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