Beruflich Dokumente
Kultur Dokumente
DUE DILIGENCE
REVISED AND UPDATED EDITION
iii
CONTENTS
PAGE
List of Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v
1. Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2. How To Use The Due Diligence Handbook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3. Overview Of Entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4. Compatibility With Investment / Acquisition Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
5. Capitalization And Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
6. Organization And Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
7. Relationships With Outside Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
8. Description Of Products And/Or Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
9. Revenues And Market Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
10. Marketing Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
11. Customer Service. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
12. Inventory Control And Purchasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
13. Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
14. Physical Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
15. Computer, Communications And Information Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
16. Financial Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
17. Legal Affairs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
18. Security And Safety. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495
19. Human Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
20. Land And Buildings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541
21. Introduction To Financial Analyses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559
22. Balance Sheet Analysis - Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 565
23. Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 587
24. Operating Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593
25. Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613
26. Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 621
27. Capital Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627
28. Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 633
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1-00
SECTION 1
PREFACE
CONTENTS
SUBJECT
TEXT
1-01
SECTION 1
PREFACE
1-02
By a public accounting firm in conjunction with an audit performed at the request of a potential
buyer or in support of a security offering.
A due diligence investigation is more concerned with the future profit potential of the entity, whereas an audit is primarily oriented toward determining the financial condition of an entity at a past
moment in time.
In a potential acquisition situation, the due diligence investigation will place great importance on
projecting how well the two organizations will function together operationally, in addition to projecting the anticipated financial benefits.
Due diligence work is usually divided between two working teams:
(1) financial and strategic, which is typically managed by the buyers accountants and management
team; and
(2) legal, to be conducted by the buyers counsel
The business due diligence focuses on the strategic and financial issues in the transaction, such as confirmation of the past financial performance of the seller; integration of the human and financial resources of the two
companies; confirmation of the operating, production and distribution synergies and economies of scale to be
achieved by the acquisition and gathering of information necessary for financing the transaction. The legal
due diligence focuses on the potential legal issues and problems that may serve as impediments to the transaction, as well as sheds light on how the transaction documents should be structured.
Degree Of Diligence Can Not Be Accurately Defined
The degree of diligence that is required in any given investigation cannot be precisely defined. What represents due or sufficient diligence will vary greatly depending on the purpose for which the investigation
is undertaken. Even when the purpose is well defined, the extent of the investigation that is required is a
judgement call.
The difficulty in defining what constitutes sufficient diligence is apparent from the difficulty the Courts have
had in resolving litigation before them.
Accounting firms and investment bankers are being sued when their clients default on a debt security or when the market price of an equity security takes a dive.
Corporate directors and officers are increasingly the subject of litigation when they make what
turns out to be a bad acquisition.
The savings and loan crisis and the several recent bank and insurance company failures are
spawning a number of legal actions in which the diligence of the regulators is being questioned.
1-03
1-04
1-05
Re: Sarbanes-Oxley
In the post Sarbanes-Oxley world, due diligence is much wider and deeper in its scope than ever before,
especially if the prospective buyer is a public company or a company with plans to go public within the next
18 months
And the list goes on . . . . . .
External events, not under the control of the acquirer or investor, are often blamed for these poor performances.
However, in most cases, adequate due diligence would have identified the potential impact of these events
well in advance. Thus their impact could have been avoided or, at the very least, minimized.
Clouds in the title to critical tangible (real estate, equipment, inventory) and intangible (patents,
trademarks, etc.) assets. Be sure the seller has clear title to these assets and that they are conveyed
without claims, liens and encumbrances.
Employee matters - there are a wide variety of employment or labor law issues or liabilities which
may be lurking just below the surface which will not be uncovered unless the right questions are
asked. Questions designed to uncover wage and hour law violations, discrimination claims, OSHA
compliance, or even liability for unfunded persons under the Multi-Employer Pension Plan Act
should be developed. If the seller has recently made a substantial workforce reduction (or if you as
the buyer are planning post-closing layoffs), then the requirements of the Worker Adjustment and
Refraining Notification Act (WARN) must have been met. The requirements of WARN include
minimum notice requirements of 60 days prior to wide scale terminations.
1-06
1-07
they are responsible for and have evaluated the companys disclosure controls and procedures, and
internal controls over financial reporting.
b) Under Section 906 of Sarbox, senior officers can be subject to potential criminal liability if they
falsely, knowingly or willfully make an inaccurate Section 302 certification.
These provisions together obligate the buyer CEO and CFO to certify the financial statements
and internal disclosure controls of the combined company as of the end of the first quarter postacquisition. In major acquisitions, this can be an impossible task if substantial due diligence is
not done prior to the closing.
c) Under Section 404, a company has to establish and maintain adequate internal control structures and
processes to allow for accurate financial reporting. In the companys annual report, senior executives
need to assess and report on the effectiveness of these internal control structures and processes.
Further, the companys auditors must provide an independent report on managements assessment.
Taken together, these measures require reporting companies (and companies otherwise observing these
requirements) to:
9
1-08
review and, if necessary, adopt new liability assessment and reporting practices;
regularly obtain and evaluate insurance company risk assessments for the companys properties;
include environmental matters in their Item 303 MD&A;
discuss pending and threatened litigation and regulatory enforcement actions in their periodic reports;
disclose and value contingent liabilities in their financial statements, including those related to
legal, operational, warranty and environmental issues;
implement and periodically evaluate Section 404 internal controls and procedures;
perform the actions called for by their internal controls and procedures, including maintaining internal records, establishing milestones for regularly evaluating known problem areas, searching out new
problem areas, and providing reports up and down the management chain;
have all of the above reviewed, evaluated and certified to by senior management; and
have all of the above formally reviewed and audited by their accountants
Among other things, audit committees must enact whistle-blowing procedures to report questionable accounting or auditing practices. The buyer should also compare the targets internal controls
with its own to identify any deficiencies or differences. This will enable the buyer to prepare integration steps to harmonize both sets of control procedures after closing.
In particular, acquiring companies need to:
expand their review of publicly available information to include the EPA ECHO list and periodic
reports filed by the target with the SEC;
specifically inquire about their targets internal review processes and procedures;
review the targets internal operational, real estate, intellectual property, insurance, litigation and
environmental policies;
examine the internal committees charged with monitoring and assessing the targets Sarbox compliance, including getting a list of committee members and their functions;
consider whether other internal procedures might touch on managerial, financial and operational
issues (for example, as part of the targets accounting and legal functions);
inquire about what is generally known as the Disclosure Controls Committee, a general oversight
committee that may gather and evaluate information generated by the internal review structure;
obtain all minutes, reports, memoranda and valuations generated by these internal
procedures; and
review the work papers and reports generated by the targets auditors while assessing the companys
internal controls.
d) As a result of Sarbanes-Oxley, the duties of the audit committee have substantially increased. A review
of committee minutes often uncovers potentially important issues. How the committee resolves these
issues may indicate its effectiveness and independence. The process used by the targets audit committee to select its outside auditor, as well as the targets relationship with its outside auditor, should also
be examined. Comparing the amount of money spent on non-audit services to the amount spent on the
audit itself may suggest the relative importance of each to the auditor. If non-audit services are significant, the buyer should consider potential exposure to bias that could affect the integrity of the audit.
10
1-09
Have the disclosure controls and procedures been followed consistently in crafting the sellers
public disclosures?
Does the seller have a Disclosure Committee and, if so, what function has it played in reviewing the
sellers public disclosures? What is the role of the General Counsel? What is the outside auditors
role in the process? Some buyers will insist on having their outside auditors evaluate the sellers
financial statements and communicate with the sellers outside auditors, without seller management
present. Access to the sellers outside auditors will be a critical part of the diligence process.
Does the Audit Committee, or other independent committee of the board of directors, oversee the
effective operation of the sellers disclosure controls and procedures? What do the minutes of the
relevant committee meetings reflect, if anything, in this regard?
II. Does the seller maintain effective internal control over financial reporting?
Many companies will have to include a management report on internal control for the first time
in their 2004 10-Ks in accordance with Sarbox Section 404 and the SECs implementing rules
hence the question has arisen whether the report of buyers management must encompass the sellers internal control, even if the sellers operations may not be fully integrated into those of the
buyer. The SEC staff has acknowledged that it might not always be possible to conduct an assessment of a sellers internal control over financial reporting within the period between the consummation of the merger and the date the buyers management must make its own internal-control
assessment of the combined company. Question 3 of the SEC staffs June 2004 FAQs on internal
control allows buyers management to defer reporting on the sellers internal control, but only if
the buyers management refers in its 404 report to a discussion in its Form 10-K explaining the
basis for the limited scope of managements assessment that is, why the 404 report excludes the
sellers business. Additionally, the staff indicates in this FAQ that the period in which management
may omit an assessment of an acquired businesss internal control over financial reporting from its
own internal-control assessment may not extend beyond one year from the date of acquisition. Nor
may such assessment be omitted from more than one annual management report on internal control over financial reporting.
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1-10
Notwithstanding the accommodation from the SEC staff, can sellers management give a clean
internal control assessment? This must be determined during the diligence process, and provided
for in the sellers representations and warranties.
If the seller is a public company, is it likely to receive a clean audit from its independent auditor
on the sellers internal control over financial reporting? (As noted, this assessment will be required,
for the 2004 fiscal year, from many companies management under Section 404 of Sarbox).
Companies that report on a calendar-year basis to the SEC, and their outside auditors, already
should be assessing the effectiveness of existing financial reporting controls with a view toward
remediation where necessary or appropriate to assure compliance by the end of the 2004 fiscal year
(the evaluation date for managements report). We understand that the Big Four accounting firms
have been signaling to audit clients that they may have material control weaknesses that could preclude the auditor from issuing a clean report as of the close of the December 31 fiscal year-end.
(Nor could management conclude that the companys internal control was effective, in the event of
a material weakness.)
If the seller has any internal control problems, how will they be corrected and, even if corrected,
is there sufficient potential liability exposure on the part of the buyer to warrant abandonment of
the deal? What sort of disclosure will be made, at a minimum, in the sellers pre-closing 10-Qs
and 10-Ks regarding possible control deficiencies identified during the due diligence process?
Have the CEO and CFO of public sellers provided the required SEC certifications under Sections
302 (relating to both disclosure controls and procedures and internal control over financial reporting) and 906 of Sarbox?
III. Are there any issues relating to the sellers financial statements that are significant enough to interfere with
the ability of the buyers CEO and CFO to certify SEC reports in the future?
Have there been any recent waivers of or amendments to the sellers code of ethics under Section 406
of Sarbox (applicable to the sellers CEO, CFO and other senior financial officers)? If the sellers
stock is listed on a national stock exchange or quoted in Nasdaq, has the seller established the broadbased ethics code called for by the exchange or Nasdaq under Sarbox-induced revisions to SRO governance listing standards? Is there any evidence that either or both codes are not being enforced?
Have there been any concerns or allegations regarding auditor independence; for example, have
activist institutions withheld votes from audit committee members because of a perception of
excessive non-audit fees paid to the outside auditor?
Has the sellers audit committee fulfilled its enhanced oversight rule under Sarbox? Note likely
requests from buyers for access to audit committee meeting minutes, whistleblower procedures and
documentation of complaints, and pre-approval policies.
Have there been any recent whistleblower complaints received by the audit committee and, if so,
how were they handled and by whom? The buyer may request access to logs and other documentation relating to treatment of such complaints, at least where they pertain to accounting and auditing matters and/or possible CEO/CFO ethics code breaches.
If the sellers stock is listed on the NYSE, AMEX or Nasdaq, are the sellers corporate governance
practices sufficient under the enhanced governance listing standards adopted by these markets
under Sarbox?
If any of the sellers directors will serve on the buyers board, are there any lack of independence
or conflicts of interest issues from the buyers perspective?
12
1-11
Are there any loans or extensions of credit to the sellers executive officers and directors in violation of Section 402 of Sarbox?
Entity
This term has been used to describe the activity that is the subject of the due
diligence investigation.
Since due diligence investigations are not limited to the acquisition of one business by
another, such terms as candidate, target and seller are not appropriate.
Also, the due diligence investigation may be directed toward a division, a subsidiary or merely a portion of a business organization. Therefore, such terms as company or firm are too
broad to be generally applicable.
Investigator
As noted above, due diligence activities are not limited to acquisitions. Therefore, the term
buyer is not appropriate.
Revenue
The term revenue has been used rather than sales since it seems a more appropriate term
when both services and manufacturing activities are considered.
13
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SECTION 2
TEXT
15
2-01
SECTION 2
17
2-02
The footer block across the bottom of each form can be used in a variety of ways.
Use Of Reference Box
The Reference box can be used for various purposes.
The preparer can be a member of the investigators Due Diligence Team or a person on the staff of
the entity being investigated.
Use Of Reviewed By Box
This box should contain the name or initials of the individual charged with the responsibility of reviewing the
completed form.
This can be a staff member of the entity being investigated, the leader of the investigating companys Due Diligence Team, or possibly the Chief Executive Officer of either entity. It may also be
an outside attorney, accountant, or consultant.
Use Of Revision Box
Some forms may be capable of being filled out completely and correctly the first time. Others may undergo
several revisions.
This box provides a means of keeping track of which form represents the latest information.
It is recommended that the letter O, be placed in this box at the time the Original entry is made.
Subsequent revisions can be numbered 1, 2, 3, . . . etc.
Use Of Date Box
This box should contain the date the original form or the indicated Revision was completed.
Use of Section And Page boxes
These boxes can be used to designate the location of the completed form in the investigators Due Diligence
Report or other document.
Possible Elimination Of The Header And/Or Footer Block
It may not be desirable to include the information provided in the header and footer during the due diligence
activity in the final Due Diligence Report. In this case the header and/or footer boxes can be trimmed off and
the remaining portion of the page pasted on the appropriate page of the final document prior to duplication.
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If the objective is to qualify a company for a conservatively structured and well collateralized loan,
the investigation need only proceed to the point where the borrowers ability to meet the debt service payments, under any reasonable set of assumptions, is assured.
At the other extreme, if the management and Board of Directors of a public company are going
to put their reputations and their shareholders investment on the line in a major acquisition, the
due diligence requirements can be staggering. One need only review the low success rate of
acquisitions to become aware of the complexities and need for thoroughness that is involved. The
potentially different management styles, the need to project the combined earning potential of two
dissimilar companies operating as a single unit, and the ability to determine in advance how best
to integrate the two organizations, add greatly to the due diligence requirements.
The due diligence requirements associated with underwriting a public offering fall somewhere
between these two extremes. In this case the complexities associated with merging two separate
organizations is not a factor. However, investment bankers have a heavy fiduciary responsibility to
both their client and the investing public. Consequently, their due diligence investigation is a vital
part of their underwriting activities.
The need to meet these varying demands in a single document explains the extent and detail of the information
requests identified herein. In many cases only a fraction of this information will be required.
Therefore, the second task - after selection of the Due Diligence Team - is for the Team to identify the depth
of information required.
Establishing Priorities For The Due Diligence Investigation
After the information requirements have been established, the third very important activity is to establish the
priorities and responsibilities for gathering the data.
One can readily anticipate the reaction of a potential seller of a business if confronted with a request to fill
out even a fraction of the forms in this Handbook.
Therefore, it is vital to prioritize the information requests and determine the appropriate member, or members,
of the Due Diligence Team to obtain the information.
The loose leaf format of the Handbook is designed to facilitate the prioritization and assignment process.
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It is recommended that the Chief Executive Officer, or his designee, schedule frequent meetings with the Due
Diligence Team.
The primary objectives of these meetings are:
When is it appropriate to formalize the results of the investigation in a report to the appropriate
level of management?
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SECTION 3
OVERVIEW OF ENTITY
CONTENTS
SUBJECT
TEXT
FORM
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Background Information On Entity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Form 3-01
Financial Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Form 3-02
21
3-01
SECTION 3
23
ENTITY
Form 3-01
FAX
IDENTIFICATION NUMBERS
FEDERAL I.D. NO.
DUNS NO.
TOP MANAGEMENT
CHAIRMAN
PRESIDENT
C.E.O.
C.F.O.
REF.
PREPARED BY
REVIEWED BY
25
REVISION
DATE
SECTION
PAGE
ENTITY
Form 3-01
NET
REVENUE
($000)
PERCENT
OF TOTAL
NET
REVENUE
ESTIMATED
MARKET
SHARE
MAJOR COMPETITORS
100.0%
Note: (1) Most recent twelve months ending _____________ . Array in descending order of net revenues.
REF.
PREPARED BY
REVIEWED BY
26
REVISION
DATE
SECTION
PAGE
ENTITY
Form 3-02
FINANCIAL SUMMARY
YEAR
NET REVENUE
PRETAX INCOME
NET INCOME
PRETAX INCOME
AS A PERCENT
OF NET
REVENUE
NET INCOME AS A
PERCENT OF
NET REVENUE
(Dollars In Thousands)
20
20
20
20
20
NET REVENUE
20
PRETAX INCOME
NET INCOME
20
20
20
20
BEGINNING EQUITY
ENDING EQUITY
AVERAGE EQUITY
PRETAX INCOME AS
A PERCENT OF
AVERAGE EQUITY
(Dollars In Thousands)
20
20
20
20
20
REF.
PREPARED BY
REVIEWED BY
27
REVISION
DATE
SECTION
PAGE
4-00
SECTION 4
TEXT
FORMS
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Compatibility With Investment/Acquisition Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Form 4-01
Form 4-02
Form 4-03
Form 4-04
Form 4-05
Form 4-06
Form 4-07
Form 4-08
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4-01
SECTION 4
A great deal of time, expense and frustration can be saved by avoiding the heavy analytical work
that is required for a complete due diligence investigation.
The majority of the responses called for in this section apply primarily to evaluating an entitys compatibility with a prospective buyers objectives in a potential acquisition situation.
This is not an accident As noted previously, the due diligence requirements are greatest in a potential acquisition situation. Here one is dealing with all the issues that come into play within each organization operating
separately - with the added challenge of merging them into a single, finely tuned organization.
Compatibility With Investment/Acquisition Objectives - Form 4-01
Form 4-01 is designed to identify a potential investors primary investment objectives. When completed, this
form will provide the basis for an initial screening of alternative investment opportunities.
Needless to say, very few investment opportunities will meet all of a potential investors objectives. Therefore,
it is desirable to establish a system for ranking the degree of importance a potential investor places on each
of the characteristics.
Compatibility With Investment/Acquisition Criteria - Form 4-02
As long as the potential investors/acquirors are realistic in their expectations, it is anticipated that many
opportunities will pass the objective screening. To further reduce the number of opportunities to a manageable level, it is desirable to apply selected financial criteria to the potential investments that pass the initial screening. Form 4-02 is provided for this purpose.
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4-02
External factors can have a significant impact on the success of an investment. Form 4-03 provides an unsophisticated, nonanalytical, method for evaluating these potential impacts.
Check marks can be placed in the appropriate column opposite each of the identified factors.
A simple count of the number of check marks in each column will provide a clue as to the potential impact of these events and trends.
While the number of marks alone is not very significant, comparing the number of positive and
negative marks of alternative investments can be meaningful.
Also identifying in advance where the opportunities and risks lie will permit an alert management to maximize the benefits from the positive factors and minimize the impact of the negative factors.
Potential Benefits From Acquisition - Form 4-04
Form 4-04 provide a similar means for determining, on a nonanalytical basis, where the major benefits and
risks may lie in a potential acquisition. Many of the initial responses will be obvious from the nature of the
proposed acquisition. However, the final responses to many of the items listed will depend on the results of
analyses called for in the subsequent sections of the Handbook.
Here again, the primary benefit of this cursory analysis is to alert the potential acquirors management to the
areas of potential risk so that the impact of these risks can be minimized. This preliminary analysis will also
influence where the Due Diligence Team should concentrate its efforts in the subsequent reviews.
Potential Impact Of Locational Factors - Form 4-05
Many an investment, be it the purchase of shares in a company or the acquisition of the entire company, has
looked good on paper but failed due to locational factors.
The flight of many companies to the sunbelt areas of the U.S. is one example.
The recent flight of companies to areas with favorable labor and/or tax environments is another
example.
Form 4-05 was developed to identify the benefits and potential problems associated with investments in different geographic areas.
Characteristics You May Wish To Avoid - Form 4-06
Form 4-06 list a number of characteristics of businesses you may wish to avoid in your investment strategy.
It is important to point out that many successful businesses have one or more of these characteristics. Therefore,
they should not be looked upon as fatal weaknesses, but rather as items that present special challenges.
Some companies have found profitable niches in operations that discourage potential competitors. The
important consideration is to be aware of how your investment, or your clients investment, intends to overcome, or benefit from these potential difficulties.
Why Is Entity Available? - Form 4-07
Knowledge of why an entity is available for acquisition is a vital input to the purchase decision. Form 4-07
list some of the major reasons why owners of private companies or boards of directors of public companies
choose to sell a business.
Space has been provided to list both the stated reason and other possible reasons that may surface during the
due diligence investigation. The important point is: do not accept the stated reason without further investigation.
The answers to the questions posed in the box at the bottom of Form 4-07 can also be revealing - if accurate
answers are forthcoming.
32
4-03
33
ENTITY
Form 4-01
RANK
(2) Desirable.
ENTITY FIT
CHARACTERISTICS DESIRED
RANK
ENTITY FIT
REF.
PREPARED BY
(2) Desirable.
REVIEWED BY
35
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-02
VALUES SOUGHT
ENTITY
(Dollars In Thousands)
Range Of Investment
$ __________________ To $ __________________
Minimum Of _______ %
Minimum Of _______ %
Minimum Of _______ %
Minimum Of _______ %
Minimum Of _______ %
Minimum Of $ __________________
Minimum Of _______ %
Minimum Of $ __________________
Minimum Of _______ %
Minimum Of _______ %
Minimum Of _______ %
Minimum Of _______ %
Minimum Of _______ %
Debt/Equity Ratio
Maximum Of _______ : 1
Maximum Of _______ %
REF.
PREPARED BY
REVIEWED BY
36
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-03
NO
IMPACT
NEGATIVE
SOMEWHAT
POSITIVE
VERY
POSITIVE
SECTION
PAGE
REF.
PREPARED BY
REVIEWED BY
37
REVISION
DATE
ENTITY
Form 4-03
NO
IMPACT
NEGATIVE
SOMEWHAT
POSITIVE
VERY
POSITIVE
TECHNOLOGICAL FACTORS
Integration of computer and communications systems
Increasing power and lower cost of personal computers
Utilization of world wide web and internet
Development of multimedia technology
Miniaturization of electronic components and equipment
Advances in fiber optic technology
Advances in genetic engineering
Development of electric powered vehicles
Advent of an economic supersonic transport
Development of high speed rail services
Deregulation of previously regulated industries
REF.
PREPARED BY
REVIEWED BY
38
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-04
NO
IMPACT
NEGATIVE
SOMEWHAT
POSITIVE
VERY
POSITIVE
REF.
PREPARED BY
REVIEWED BY
39
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-04
NO
IMPACT
NEGATIVE
SOMEWHAT
POSITIVE
VERY
POSITIVE
REF.
PREPARED BY
REVIEWED BY
40
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-04
NO
NEGATIVE
IMPACT
SOMEWHAT
POSITIVE
VERY
POSITIVE
SECTION
PAGE
REF.
PREPARED BY
REVIEWED BY
41
REVISION
DATE
ENTITY
Form 4-04
NO
IMPACT
NEGATIVE
SOMEWHAT
POSITIVE
VERY
POSITIVE
REF.
PREPARED BY
REVIEWED BY
42
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-05
NO
IMPACT
NEGATIVE
SOMEWHAT
POSITIVE
VERY
POSITIVE
REF.
PREPARED BY
REVIEWED BY
43
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-06
AVOID
WILL
CONSIDER
GENERAL
Business you dont know.
MANAGEMENT
One man company.
Lack of management depth.
Significantly different management style.
TYPE OF BUSINESS
Short product life cycle
Highly cyclical.
Highly seasonal.
High technology.
Mature product lines.
Heavy government regulation.
Heavy reliance on defense business.
COMPETITIVE ENVIRONMENT
Low market share.
Much larger and/or stronger competitors.
Competitors have significant cost advantage(s).
Poor reputation vis-a-vis competitors
REF.
PREPARED BY
REVIEWED BY
44
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-06
AVOID
WILL
CONSIDER
PRODUCTION CHARACTERISTICS
Obsolete or rundown facilities.
Obsolete or rundown equipment.
Processes involve environmental problems.
Labor intensive.
High labor cost environment.
Unionized.
Energy intensive.
High energy costs.
FINANCIAL CHARACTERISTICS
Capital Intensive.
Highly leveraged post-acquisition.
Acquisition involves substantial goodwill.
Acquisition will dilute earnings and/or book value per share.
Poor record of meeting financial projections.
REF.
PREPARED BY
REVIEWED BY
45
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-07
NOT
APPLICABLE
STATED
REASON(S)
OTHER
POSSIBLE
REASONS
BUSINESS REASONS
Business is not currently producing adequate level of earnings.
Increasing competition from stronger and/or lower cost
producers.
Future earnings are expected to deteriorate due to:
Increasing wage and/or benefits demands by labor.
Increasing operating costs.
Increasing debt service costs.
Increasing taxes.
Cannot, or does not wish to make the heavy expenditures
required to:
Expand and/or automate facilities to remain competitive.
Develop new and/or updated products.
Meet new environmental regulations.
Meet new OSHA regulations.
REF.
PREPARED BY
REVIEWED BY
46
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-07
NOT
APPLICABLE
STATED
REASON(S)
OTHER
POSSIBLE
REASONS
[ ] Yes
[ ] No.
How long has the entity been on the market? __________ months.
What other companies are known to have looked at this entity? __________________________________
[ ] Yes
[ ] No.
REF.
PREPARED BY
REVIEWED BY
47
REVISION
DATE
SECTION
PAGE
ENTITY
Form 4-08
HOW DOES THIS ENTITY RANK AGAINST OTHER SIMILAR INVESTMENT/ACQUISITION CANDIDATES?
ENTITY
RANK
ENTITY
RANK
WHAT ARE THE PRINCIPAL REASONS THIS ENTITY SHOULD BE GIVEN PREFERENCE FOR FURTHER
CONSIDERATION?
REF.
PREPARED BY
REVIEWED BY
48
REVISION
DATE
SECTION
PAGE
5-00
SECTION 5
TEXT
FORM
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Summary Of Capitalization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Form 5-01
Form 5-02
Form 5-03
Form 5-04
Form 5-05
Form 5-06
Form 5-07
Form 5-08
Capitalization - Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Form 5-09
Form 5-10
49
5-01
SECTION 5
The long-term portion of notes due banks, insurance companies and other lenders.
The long-term portion of debt securities.
The long-term portion of mortgage loans.
The long-term portion of capitalized leases.
The long-term portion of accrued warranty costs.
The comments below suggest what to look for in this completed form.
WHAT TO LOOK FOR
Debt/Equity Ratio
The financial community places great emphasis on the overall ratio of long-term debt to shareholders equity. As will be noted in Section 29, many analysts get nervous if the long-term debt
exceeds the shareholders equity.
While this should be considered a red flag, it should not, by itself, be the sole determinant
of an entitys long-term credit worthiness.
Other measures, such as the number of times the projected free cash flow covers the debt
service payments, should be given consideration. This measure is also discussed in greater
detail in Section 29.
Interest Rates
The entries in the long-term debt section of this form will indicate what the entity is paying
for the funds it has borrowed from banks, insurance companies and other long-term lenders and from the investing public on its bonded debt. Needless to say, the higher the interest rate,
the greater the drag on profits and cash flow.
Compare the interest rates with the amount of the debt they represent. If abnormally high interest rates apply to the largest portions of the debt, they will have a greater impact on profits and
cash flow.
As will be noted subsequently, bonded debt frequently contains a call feature: bank and
insurance company notes can frequently be paid off before maturity with little or no penalty.
Consequently, if the entity is generating sufficient cash, it may be appropriate to liquidate or
refinance the high interest rate obligations.
51
5-02
The features to look for in the individual forms of debt and equity securities are discussed below.
Capitalization - Common Stock - Form 5-02
Form 5-02, when completed, will provide a reconciliation of the number of authorized shares of common
stock, the number of shares outstanding, and the shares that are reserved for various purposes.
If more than two classes of common stock have been issued, additional forms will be required.
WHAT TO LOOK FOR
Potential Dilution
It is particularly important to focus on the number of reserved shares in comparison to the number of currently outstanding shares. These shares, if and when issued, may represent a significant dilution in the value of the previously issued shares.
This potential dilution is important to individual shareholders, who may suffer a loss in the
market value of their shares.
Managements position on shares reserved for employees is that the benefits that result from
more motivated employees offset the potential dilution.
The rationale behind the shares reserved for potential conversion of other securities is that they
provide a sweetener that reduces the cost of the funds generated from the sale of the
underlying security.
The potential dilution can also be of major significance in valuing an entitys shares in a
prospective acquisition situation. The potential dilution will impact the share price in a purchase of stock acquisition and the exchange ratio in a stock-for-stock transaction.
Consequently, depending on the timing and the precise terms of the various purchase or conversion agreements, it may be appropriate to base all investment decisions on the fully diluted
value of the shares.
Acceleration Of Purchase and/Or Conversion Dates
It is important, in a potential acquisition, to review the underlying employee stock purchase
plans and convertible security documentation. Some of the plans and securities provide for the
acceleration of the purchase or conversion dates in the event the entity is acquired by, or mergered with, another firm.
Restricted Stock
If restricted stock represents a significant portion of the total shares, the reasons for the restrictions and the terms under which the restrictions can be lifted, should be obtained.
52
5-03
The history of recent common stock offerings, presented in the the middle table on Form 5-03, will help
gauge the investment communitys past response to the entitys public offerings. A favorable trend will make
it much easier for a buyer to finance the acquisition if outside funds are necessary.
Common Stock - Dividend Record - Form 5-04
A stocks dividend record is of paramount importance to a large segment of the investment community. Form
5-04 is provided to record this information.
WHAT TO LOOK FOR
Cash Dividends
A steady increase in the dividend over time is preferred to one that fluctuates, even though the
peak rate may be higher. No one objects to an increase in a firms dividend. However, the need
to subsequently reduce the dividend can play havoc with the stocks market price. Therefore,
in establishing the dividend, management should select one that can be sustained under very
conservative earnings projections without depriving the company of funds needed for profitable expansion opportunities.
Dividend Payout Rate
The dividend payout rate is the percentage relationship between the dividends paid and the
entitys earnings.
Investors looking for long term market appreciation do not like to see a consistent dividend
record being maintained at the expense of too high a payout rate. Too high a payout can
adversely impact the entitys ability to fund potential growth opportunities.
Dividend Yield
Investors looking for current income pay particular attention to the yield represented by the
dividends.
53
5-04
54
5-05
55
5-06
Form 5-09, when completed, will summarize the most common characteristics of corporate bonds. However,
the fertile minds of the investment banking community are constantly coming up with new twists.
Consequently, if the entity has some of these hybrid securities outstanding, it may be necessary to list their
characteristics on a separate page.
Form 5-10 will provide information on the current yield and ownership of the entitys bonds.
WHAT TO LOOK FOR
If the entity is covering the debt service payments on its bonds with a comfortable margin, and
can confidently be projected to do so in the future, the main concern may be to determine if
profits can be improved by refinancing the bonds to take advantage of lower interest rates that
may be available.
However, if the bonds are in default, or could possibly be in default at some future time, some of
the terms and conditions contained in the Indenture Agreement can have serious consequences. A
qualified corporate attorney should review these Agreements on all outstanding issues.
Security Provisions
Although defaulted secured bondholders may not have voting rights, if the security they hold
is vital to the ongoing operation of the company, they are in an extremely strong position to dictate how the company is reorganized. As an alternative they may be able to demand (some
might call it extort) favorable redemption terms.
Consequently, the form of the security and its terms under default conditions can become
very important.
Debt Service Requirements
Requirements for sinking funds and/or serial retirement of the bonds can have a significant
impact on the entitys cash flow.
Potential Dilution
The exercise of warrants that may be attached to the bonds and/or conversion features may represent substantial future dilution of the current shareholders equity. (See Form 5-02.)
56
ENTITY
Form 5-01
SUMMARY OF CAPITALIZATION
FORM OF CAPITAL
AS OF MOST
RECENT AUDIT
(1)
AS OF LATEST
QUARTER
(2)
LONG-TERM DEBT
PREFERRED STOCK
COMMON STOCK
Retained Earnings
Adjustments (Currency translation, pension funds, etc.)
Treasury Stock At Cost
REF.
PREPARED BY
REVIEWED BY
57
REVISION
DATE
SECTION
PAGE
ENTITY
Form 5-02
SINGLE CLASS
OR CLASS A
CLASS B
NOTES
Treasury Stock
Number Of Shareholders
LISTING INFORMATION
Exchange Where Listed
Stock Symbol
Lead Underwriter(s)
NOTES
REF.
PREPARED BY
REVIEWED BY
58
REVISION
DATE
SECTION
PAGE
ENTITY
Form 5-03
SHAREHOLDER RIGHTS
Shareholders meeting notice period.
Days
MOST RECENT
Effective Date
Number of shares
Price per share
Market value
Net proceeds
MISCELLANEOUS ITEMS
Are all the shares validly issued, fully paid, and nonassessable? [ ] Yes [ ] No If not, please explain:
Are there any restrictions against the use of these shares as collateral? [ ] Yes [ ] No If so, explain:
Are there any buy-sell agreements between shareholders? [ ] Yes [ ] No If so, please explain:
REF.
PREPARED BY
REVIEWED BY
59
REVISION
DATE
SECTION
PAGE
ENTITY
Form 5-04
20
20
20
20
20
Second Qtr.
Third Qtr.
Fourth Qtr.
Year
DIVIDEND PAYOUT
YEAR
20
20
20
20
20
Indicated Yield
STOCK DIVIDENDS
Has the Company issued stock dividends during the last five years? [ ] Yes [ ] No
If so, please provide the details.
REF.
PREPARED BY
REVIEWED BY
60
REVISION
DATE
SECTION
PAGE
ENTITY
Form 5-05
20
20
20
20
20
Second Qtr.
Third Qtr.
Fourth Qtr.
: 1
: 1
: 1
: 1
: 1
YEAR-TO-DATE PERFORMANCE
PRICE
PERFORMANCE
HIGH/LOW
LAST YEAR
HIGH/LOW
THIS YEAR
P/E RATIO
LAST YEAR
P/E RATIO
THIS YEAR
As Of _______
:1
:1
TRADING
VOLUME
VOLUME - LAST
YEAR-TO-DATE
VOLUME - THIS
YEAR-TO-DATE
TURNOVER
LAST YEAR
TURNOVER
THIS YEAR
As Of _______
REF.
PREPARED BY
REVIEWED BY
61
REVISION
DATE
SECTION
PAGE
ENTITY
Form 5-06
SHARES
HELD
(000)
PERCENT OF
TOTAL
SHAREHOLDER
SHARES
HELD
(000)
PERCENT OF
TOTAL
(As Of ___________________ )
%
DESCRIBE ANY RELATIONSHIPS THAT SUGGEST THAT ANY OF THE ABOVE INDIVIDUAL
SHAREHOLDERS MAY VOTE AS A GROUP
Family Relationships, Company Management, Shares In Same Voting Trusts, Etc.
Note: If the group is represented by one or more board members, please identify them.
REF.
PREPARED BY
REVIEWED BY
62
REVISION
DATE
SECTION
PAGE
ENTITY
Form 5-07
ISSUE OF
_______________
ISSUE OF
_______________
DISTRIBUTION OF SHARES
Shares Outstanding
Number Of Shareholders
FEATURES
Par Value
Coupon rate
per share
per share
%
per share
per share
per share
per share
REF.
PREPARED BY
REVIEWED BY
63
REVISION
DATE
SECTION
PAGE
ENTITY
Form 5-08
20
20
20
20
20
Second Qtr.
Third Qtr.
Fourth Qtr.
Year
DIVIDEND PAYOUT
YEAR
20
20
20
20
20
Indicated Yield
DIVIDEND ARREARAGES
Has the entity or its parent experienced an arrearage on its preferred dividends during the last five years?
[ ] Yes [ ] No If so, when, what amounts, and for how long?
REF.
PREPARED BY
REVIEWED BY
64
REVISION
DATE
SECTION
PAGE
ENTITY
Form 5-09
CAPITALIZATION - BONDS
DESCRIPTION
ISSUE OF
__________________
ISSUE OF
__________________
DISTRIBUTION OF BONDS
Bonds Outstanding
Number Of Bondholders
FEATURES
Denomination
Interest rate
per bond
per bond
%
REF.
PREPARED BY
REVIEWED BY
65
REVISION
DATE
SECTION
PAGE
ENTITY
Form 5-10
BOND YIELDS
CURRENT YIELD (1)
ITEM
ISSUE
ISSUE
Current Yield
BONDS
HELD
Totals
ISSUE ______________________________
PERCENT
OF TOTAL
NAME
BONDS
HELD
PERCENT
OF TOTAL
Totals
REF.
PREPARED BY
REVIEWED BY
66
REVISION
DATE
SECTION
PAGE
6-00
SECTION 6
TEXT
FORM
Board Of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
Form 6-01
Form 6-02
Form 6-03
Corporate Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Form 6-04
Management Style . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Form 6-05
Form 6-06
Form 6-07
Form 6-08
Form 6-09
Form 6-10
Form 6-11
Form 6-12
67
6-01
SECTION 6
69
6-02
The top management organization chart should be presented in Form 6-04. Individual departmental organization charts will be discussed in the appropriate sections which follow.
It is important to note that the published organization chart does not necessarily reveal how an organization
actually functions. Frequently, this chart merely represents how the Chief Executive wants the organization to
be perceived.
It will require astute observation and discussions with employees at various levels of management to determine how an entity carries out its activities on a day-to-day basis.
Management Style
Book stores and libraries are bursting with conflicting theses on this subject. There is no reason to add to the
debate here.
However, the due diligence activity will not be complete if it does not focus on at least two of the most important management considerations:
Span of control.
Delegation.
Each of these characteristics will be discussed briefly below.
Span Of Control
Span of control refers to the number of functions that are under the direct supervision of an individual
- be they the Chief Executive Officer or the Supervisor Of Plant Maintenance.
As a general rule, five to seven direct reports are considered optimum for a chief executive. A typical line
up is as follows:
A company with a high degree of public exposure can often justify a top level public relations
position.
A technically oriented business will often have the chief technologist report directly to the CEO.
CEOs of highly diversified and/or growth oriented companies often benefit from having a corporate development executive on their direct staff.
Todays emphasis on environmental issues has resulted in a few potentially vulnerable companies
raising this function to the top corporate level.
The important point is, there should be good reasons for extending the CEOs direct control over more functions than are required by the basic nature of the business.
70