Beware of those who say Due "DiLLigence"

According to Wikipedia, a Due Diligence is "an investigation of a business or person prior to signing a contract, or an act with a certain standard of care".

This definition is quite accurate and reflects what we all should do before entering a transaction. 

Real life experience shows though that, what should be a mere exercise of prudent business review, sometimes turns into a costly, resource and time wasting exercise.

I recall two quite striking cases.

Case Nr 1

One day I was invited at very short notice to Berlin. The communicated reason for the meeting was to prepare discussions for a possible IT outsourcing. When I enter the room which was located on the premises of a famous local hospital, I saw following scene:
a large space with 1 chair, 2 large tables, 20 thick folders on those tables and a smiling colleague from the sales department. The colleague started with something like "good morning Mr. di Bari, Welcome to the Data Room. These are all the documents you need. Please make sure that by the end of the day we have everything we need for this transaction".

Case Nr 2

Recently I was involved in a potential M&A transaction. The discussions have been going on for 12 months without any measurable progresses, when by chance I happened to become involved. I spent some time listening to the views of the parties and quite quickly became clear to me why there were no progresses (For a change it was the difference between price and value). I managed to agree on a range and then we defined a transaction structure and finally a schedule for the due diligence. Everything was going the right way until.... Enter the Headquarters and the Investment Bankers. Even though we agreed on an asset deal taking over an handful of assets and people, my team and I have been forced by the "augurs" above into a very expensive, time consuming and absolutely wasteful due diligence on items we did not event want by any means to consider in the transaction and whose legal and fiscal history, present and future had nothing to do with the business. "Because we have always done like that". "Because the headquarters want it". "Because we (investment bankers) think it is a good idea". An so on.....


For the few of you who are curious about my reaction I can tell you the following:

On case Nr 1 After having carefully verified that I was not a victim of a practical joke I had to call "Houston" and ask to push the reset button on this entire story. We never started again because the transaction at a closer look, was nonsensical from the beginning.

On case Nr 2 After having verified the complete unwillingness to listen by some of my bosses and colleagues, dressed with a bouquet of "yesbuts", I closed my eyes, sat tight and went through the process dreaming of the many things we could have done better and more efficiently with the time, nerves and resources wasted. We closed this transaction and was a very good deal for all. Especially for the consultants.

Here my learning on the Due Diligence :

1. if you are buying an entire company or a subsidiary or a line of business or if you are entering any agreement where you have to rely on statements or have to purchase rights assets and obligations, an extensive due diligence, supported by robust covenants and warranties is what you would consider doing
2. If you happen to be the boss or one of the top managers of a company please make sure that NOBODY in your organisation except the CEO TOGETHER with the CFO can start plan or execute any Due Diligence (let alone a letter of Intent) without proper authorisations. 
3. Finally beware  the creativity of the sales people and all those (investment bankers and consultants) who still after many years write due "dilligence". 

Here is the first  CLEARCUTCASE©: The main scope of the due diligence is to verify ALL the major assumptions that support your credible, validated and very conservative business plan. Further you would like to verify ALL the deal breakers and major risks that you have thought of BEFORE you prepare the business plan for the valuation, hence BEFORE the Due Diligence. 
If you are happy about the findings, then fix them in the contract. If you are not, correct the price, increase the warranties or exit. 

Here is the second  CLEARCUTCASE©: the best M&A transaction is very likely the one you decide not to execute 

Make sure that you brief your team very intensively on business plan assumptions, deal breakers and major risks before they start. At the end of each business day you let every team meet the others and wrap up the findings.

I am at your disposal 

Francescodibari.eu
francescodibari@blogspot.de

The abyssal difference between value and price Why “CoCo” and “CoTra” won’t help you

The abyssal difference between value and price

Why “CoCo” and “CoTra” won’t help you

Sometime I like watching documentaries on “real life” pawn shops. There is a lot going on: interesting characters visiting the shop, the most diverse objects offered for pawn or sales (from Americana to Viking swords, music instruments or firearms), a lot of side stories. The reason why I like watching this programs is the negotiation part among the pawn shop employees and the clients. I must admit that for me this is every time a great learning experience. I learn a lot and I use what I learn for M&A discussions, when I hire someone, when I am looking for a job and/or negotiate with my customers.

How so?

The typical scene is the following: A potential client walks in and offers to sell or pawn some objects. The clients try to keep the price as high as possible arguing on rarity, uniqueness, or market value of what they bring in. The pawn shop guys obviously try to negotiate the asking price down. Normally there is some discussion going on, sometimes both parties argue about provenance, rarity or similar and very often an expert is called in (typically for old books or guns) to examine the items.

The negotiating parties are far apart as long as they are talking about different things at the same time: price and value. The seller would like to agree on the highest possible price, at which normally there is no value left in for the buyer. The buyer then start speaking about the price he or she is going to sell the item in the shop for. When the parties recognize the value which is intrinsic in the transaction for each party, then it is very easy to determine a dollar amount, a price, to agree upon.

Even among very qualified counterparts there is quite a bit of confusion between price and value. I use a very simple, almost obvious sentence to clarify what I am talking about:

Price is what you pay, value is what you get.

Do you think this is trivial? You should think again. In numerous M&A transactions, parties on all sides tend to mix up these two different concepts. When you have to figure out the value of a company you would like to acquire, there is only one way to determine your decision. What you would like to know BEFORE acquiring a company is how much cash will remain in your hands after you pay a price, align the target to your operation, and perform the necessary investments and cost cutting. And this in the short, medium and long term[1].

What should really matter to you is the amount of money which you, at the end of the day, can make with this acquisition.  Incidentally: your advisors may also recommend you to purchase a company for “strategic” reasons, for example to access certain markets or take over important customer agreements. Accept to do so only if the cash you expect at the end of a reasonable period of time is more than the amount you have in your pocket before the transaction.

Here another piece of advice you will never find in any business book:

every time someone uses the word strategic, you should consider replacing it in your mind with the word “expensive” (alternatively: “very expensive”).

The world will start immediately making a lot more sense to you if you do so.

Back to our pawn shop scenery. If the guys clients and shop employees would speak from the beginning about the value, the money each of them can make with the transaction, there would be an outcome almost immediately. In the note below I have described the same scene twice: the typical one and the alternative one if both parties spoke about value and price at the same time. If you are  into this kind of show please check the footnote2]

In a nutshell: there is an abyssal difference between price and value. Recently I have seen a company paid 3 digit million USD amount and incapable of generating a single digit positive cash flow. The price was shooting away from the value based on CoCo, CoTra and love[3]

Besides other effects, one of the most misleading bias when acquiring a company is considering CoCo and CoTra as valuation methods.

CoCo stands for Comparable Companies and CoTra for comparable transactions. There is someone out there who charges you a lot of money for giving you a list of CoCos and CoTras with the purpose of justifying and substantiating their way off valuation (and fees).  These guys (mostly in good faith) mix up valuation and pricing and bring in their assessment of a transaction similar companies which have a value x on the market or other companies which have been sold for a certain price.

Mixing price and value ain’t a good thing

Here is an example why it shouldn’t be done.

A German guy some time ago happened to own an old car, a VW Golf, which used to belong to Mr Ratzinger, a Cardinal from Regensburg. When Mr Ratzinger was elected Pope of the Roman Catholic Church, the car became an interesting object and was auctioned and finally sold for 188.938 Euro und 88 cents to an Online Casino. The value and the price of such a car in the German market is typically fairly below 10,000 Eur.

I am exaggerating a bit on purpose, but the guys using CoCo and CoTra as valuation elements are telling you that if you want to buy or sell a used VW Golf you need to keep in mind that one was sold for over 189 Thousand Eur. Or that the value of certain VW Golf can reach the same amount.

Although I personally find it very interesting to find out how much the Pope’s car has been sold for, or what is the market value of a similar company, at the end of the day the only thing I care is: if I buy this target, am I better off in term of cash in the short, medium and long run[4]?  

This is a CLEARCUTCASE©: CoCo and CoTra won’t help you,

At all.

(Unless you would like to pay for them as conversation items)

In a nutshell:

1.     When valuing an acquisition think cash only

2.     If you hear “strategic” please understand “expensive” or “very expensive”

3.     If someone is showing you CoCos and CoTras you run the very big risk to confuse price and value.

4.     If the individual above is charging you for this analysis please do contact me: I have a lot of recommendation on how to spend your monies for personal fun or social benefit

I am at your disposal

francescodibari.eu
http://www.francescodibari.eu/blog/

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[1] Here my warmest recommendation ist you use the net present value of the free cash flow method-and nothing else![2] Consider the typical scene:Pawn shop guy: “hey man, how are you doing?”Client: “hi dude, howrudoin, I brought a gun, a peacemaker. It belonged to my grand grand father who was a famous sheriff in the orange county. ”Pawn shop guy: “what do you want to do with it, pawn or sell?”Client: “sell it”Pawn shop guy: “how much do you want for it?”Client: “10,000 USD (price). It is a great affective value for us”Pawn shop guy: “that is not gonna happen, the peacemaker go for no more than 2,000 USD (price). Can you prove it belonged to sheriff xx”?Client: “no, but my parents told me so and I trust them”Pawn shop guy: “I can give you 1000 USD (price) for it?”Client: “no man, it is too low (value), you just said it is worth 2,000 USD (price)”Pawn shop guy: “that is the auction price on a good day. I need to buy the gun, restore it for 500 USD. It will sit here for months and I can hope to sell it for 2,000 USD (price)?Client: “can you do 1,100? ”Pawn shop guy: let us split the differencehttp://www.francescodibari.euNow the same scene in the perfect world:Pawn shop guy: “hey man, how are you doing?”Client: “hi dude, howrudoin, I brought a gun, a peacemaker. It belonged to my grand grand father who was a famous sheriff in the orange county. ”Pawn shop guy: “what do you want to do with it, pawn or sell?”Client: “sell it”Pawn shop guy: “how much do you want for it?”Client: “how much you can sell it for?”Pawn shop guy: “2,000 USD” (price).Client how much would it cost you to restore it?Pawn shop guy: 500 USDClient: “OK man, 1,100 (value) for me-I found this piece of junk in the basement, so any amount is fine, 400 for you (value)Pawn shop guy: “can you do 1,000? ”Client: let us split the differencePawn shop guy: deal![3]The buyer fell in love with the target- please read my previous post[4] I am referring to people who live very long or believe in a life after death or at least do not believe in Keynes theories. “In the long run we are all dead“ (J.M. Keynes)

That strange good feeling of falling in love…

That strange good feeling of falling in love…
Who doesn’t know it? That strange good feeling that the English metaphor “butterflies in the stomach“ (in German “Schmetterlinge im Bauch”) describes so well! That feeling adds spice and joy to our lives. Does this feeling exist in business life? Yes it does and I have observed it many times, especially in the M&A environment, typically on the buy side. Many business people just fall in love with a target company they would dearly like to acquire. The factors triggering this compulsive desire to acquire are multiple. In my view they can be defined in 3 major categories: 
1)   Shortcut on the job that the acquiring company still has to complete (on the development, market or customer side) 
2)   Strong belief that the target company’s management isn’t capable or willing to seize market opportunities
3)   Bigger is better

Many times I have heard statements like “Their brand new technology would be a perfect complement to ours” or “We can win that important customer of theirs, whom we have tried to win over for years”. And I have seen many companies, small business and large-listed corporation, going for size.
The motivations above can drive you to either good or very bad acquisition. Some bad acquisitions as well as delayed divestments can mean trouble and in certain cases even the end of your business. If you happen to be a CEO or any other decision-taker in a company, no matter how large or small, my advice to you would be the following:
a.     Before thinking of acquiring a company make sure you have a strategy[1] . A company acquisition cannot be your strategy but can be one of at least three means to implement your strategy. I am always stunned by the number of companies that believe they have a strategy when they don’t. Or even worse, that develop an acquisition strategy before having a strategy at all. An acquisition is a tool, never a goal[2]. 
b.     If you ever think of acquiring a company to shortcut on your homework (strategy, sales or development), the first question you should consider is why you are trying to shortcut and if your management is really up to the challenge[3].
c.      When you choose who should support you in the acquisition process, think about their motivations. If someone is paid a certain amount of money to support you and some more once the transaction is done, this person will do anything to encourage you into a transaction, overtly or covertly. For someone out there in the market, the long term destiny of your company is not as important as the closing fee earned short term.  Your advisor (whom I recommend be chosen outside of your network and with concrete line experience) must be firm enough in his views to recommend a withdrawal from the transaction should this be in the interest of your company. I remember a very long transaction, supported by top management consultants and auditors, for which I had to fight up to the Board of one of the largest corporations.  I got the approval and the cash for the acquisition but my competence and gut feeling told me to look into the potential acquisition again. Guess what? The target’s management had planned a “walk out” soon after the completion and had started to build a clone elsewhere. It was hard for me to stop everything and to explain to the board, that no, after this entire persuasion job we needed to forget everything. It was very hard for me, but it was good for the company. 
d.     Value and price. It is astonishing how often we forget about the fundamental difference between value and price when we fall in love. If as a CEO you are willing to pay a price which goes beyond the value (and I have seen plenty of managers creatively inflating the value to reach the price), this is a CLEARCUTCASE©: you have fallen in love.
Falling in love in business or in life has its consequences.  In non-business life love can make you blind. Even if you recognise defects and vices in your partner you run the concrete risk of overlooking them. I recall due diligences report “loosing” some bruising risk-warning chapters, business plans “twisted” to account for fantasy revenues or 4th dimension synergies. 
In a nutshell: falling in love can give you that strange good feeling everybody likes.  However too much love for a target company can make you blind: do not allow it to make you stupid too. Before proposing to your next business partner it is always wise to talk to someone who is not as involved or interested as you are and whom you think is strong enough to give you also the advice you do not want to hear. 
I am at your disposal:www.francescodibari.eufrancescodibari.blogspot.de

[1] “Having or not having a strategy“. This topic deserves a special dedicated post[2] There you go, another topic: Strategy. A great step for you to make is to ask what is your company strategy. I bet in most cases you will hear something like achieve xx million revenue (!). A certain revenue figure or profitability can only be the consequence of your strategy, not the strategy. If that’s what you hear and you are an employee of that company, start updating your cv before it is too late.[3] Markets do not crash companies, management do. Another topic for this blog