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THE AMA HANDBOOK OF

DUE DILIGENCE
REVISED AND UPDATED EDITION

WILLIAM M. CRILLY and ANDREW J. SHERMAN

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Library of Congress Cataloging-in-Publication Data
Crilly, William M.
The AMA handbook of due diligence / William M. Crilly and Andrew J. Sherman. Rev. and updated ed.
p. cm.
Rev. ed of: Due diligence handbook. 1998Includes bibliographical references and index.
ISBN 978-0-8144-1382-1
1. AuditingLaw and legislationUnited States. 2. Disclosure of informationLaw and legislation
United States. 3. ValuationLaw and legislationUnited States. I. Sherman, Andrew J. II. Crilly, William.
M. Due diligence handbook. III. American Management Association. IV. Title.
KF1357.C753 2010
346.73063dc22
2009050209
2010 by William M. Crilly and Andrew J. Sherman
All rights reserved.
Printed in the United States of America.
The previous edition of this book was published as the Due Diligence Handbook, Volumes 1 and 2 by
William M. Crilly.
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Printing number
10 9 8 7 6 5 4 3 2 1

DUE DILIGENCE HANDBOOK

iii
CONTENTS

See Individual Sections For Detailed Contents


SECTION

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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29. Financial Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639


30. Income Statement Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657
31. Balance Sheet Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 679
32. Cash Flow Projections. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 699
33. Due Diligence Checklists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 707
34. Transaction - Specific Due Diligence Checklists For Acquisitions Or Investments On
Specific Dealings In Selected Industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 727
35. Sample Forms Related To Effective Due Diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737
36. Due Diligence Checklists For Special Situations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 769
Appendix A: Bibliography And Recommended Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 791
Appendix B: A Selection Of Blank Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 793
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 799
About the Authors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 827

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LIST OF FORMS, CHECKLISTS, AND OTHER DOCUMENTS


*Note: all forms in this book are available as customizable Word documents. They are on the CD provided
at the back of the book.
Section 3: Overview of Entity
3-01. Background Information On Entity
3-02. Financial Summary
Section 4: Compatibility With Investment/Acquisition Objectives
4-01. Compatibility With Investment/Acquisition Objectives
4-02. Compatibility With Investment/Acquisition Criteria
4-03. Potential Impact Of External Factors
4-04. Potential Benefits From Acquisition
4-05. Potential Impact Of Locational Factors On A Prospective Investment
4-06. Characteristics You May Wish To Avoid
4-07. Why Is The Entity Available?
4-08. Comparison With Other Potential Investment/Acquisition Candidates
Section 5: Capitalization And Ownership
5-01. Summary Of Capitalization
5-02. CapitalizationCommon Stock
5-03. Common StockMiscellaneous Information
5-04. Common StockDividend Record
5-05. Common StockPrice And Trading Volume
5-06. Common StockHolders Of More Than Four Percent Of Shares
5-07. CapitalizationPreferred Stock
5-08. Preferred Stock Dividend Record
5-09. CapitalizationBonds
5-10. Bond Yields And Major Bond Holders
Section 6: Organization And Management
6-01. Board Of Directors
6-02. Board Of DirectorsOther Affiliations And Compensation
6-03. Board Of DirectorsCurrent And Prospective Security Holdings
6-04. Corporate Organization
6-05. Corporate Management Resumes
6-06. Recent Compensation History Of Corporate Management Personnel
6-07. Company Security Holdings Of Corporate Management Personnel
6-08. Organization And Management Information Requests
6-09. Board Of Directors Opinions Of Management
6-10. Board Members Apparent Position Regarding Potential Acquisition
6-11. Overall Management Assessment
6-12. Assessment Of Individual Management Personnel
Section 7: Relationships With Outside Organizations
7-01. Relationships With Accounting Firms
7-02. Relationships With Law Firms
7-03. Relationships With Commercial Banks
7-04. Relationships With Investment Banks
7-05. Relationships With Venture Capital Firms
7-06. Relationships With Private Investors And/Or Investment Groups
7-07. Relationships With Consulting Firms
7-08. Relationships With Trade Associations
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7-09. Relationships With Other Professional Organizations


7-10. Outside Organization Information Request
Section 8: Description of Products And/Or Services
8-01. Summary Of Product Lines/Services
8-02. Individual Product Line/Service Overview
8-03. Competitive Product/Service Analysis
8-04. Product Line Positioning
8-05. Identified Product And Service Improvement Projects
8-06. Potential Future Product And Service Improvement Opportunities
8-07. Recently Discontinued Products And/Or Services; Products And/Or Services Potentially Subject To
Early Termination
8-08. New Product And/Or New Service Development Projects
8-09. New Product DevelopmentSummary Of Current Projects
8-10. Schedule Of Expenditures For Approved Development Projects
8-11. Performance On Past Development Projects
8-12. Distribution Of Company Development Funds
8-13. Source Of Total Development Funds
8-14. Trend In Development Expenditures, Salaries And Staffing Levels; Comparison Of Budget Versus
Actual Expenditures
8-15. Comparison Of Development Expenditures With Other Companies
8-16. Current Development Budget Considerations
8-17. Future Development Requirements
8-18. Accounting For Development Expenditures
8-19. Development Organization
8-20. Development OrganizationResumes Of Key Personnel
8-21. Compensation Of Key Development Personnel
8-22. Development Staffing Levels
8-23. Trend In Development Staffing
8-24. Internal Development Procedures
8-25. Current Product/Service Information Request
8-26. New Product/Service Development Information Request
8-27. Summary Of Major Development Strengths And Weaknesses
8-28. Potential Impact Of An Acquisition On The Development Organizations
Section 9: Revenues And Market Share
9-01. Trend In Total RevenuesAll Products And/Or Services
9-02. Trend in Revenues By Product Line Or Service
9-03. Trend In Market Share By Individual Product Line Or Service
9-04. Revenues By Major Customer
9-05. Trend In Revenues By Customer
9-06. Revenues By Channel Of Distribution
9-07. Revenues By Distribution ChannelDirect Sales To Customers, Retailers
9-08. Revenues By Distribution ChannelDirect Sales To Industry, Government
9-09. Revenues By Distribution ChannelSales Through Wholesale Offices, Distributors
9-10. Revenues By Distribution ChannelThrough Sales Representatives, Other Channels
9-11. Revenues By Geographic Region
9-12. Trend In Revenues By Geographic Region
9-13. Trend In Revenues By Month
9-14. Seasonal Variation In Revenues
9-15. Trend In Revenues From Commercial Negotiated Contracts
9-16. Commercial Negotiated Contracts
9-17. Commercial Negotiated ContractsRenegotiation Experience; Status Of Current Renegotiations
9-18. Trend In Revenues From Government Contracts
9-19. Government Contracts
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9-20. Government ContractsRenegotiation Experience; Status of Current Negotiations


9-21. Trend In Revenues Generated Through Independent Distributors; Ten Largest Independent Distributors
9-22. Trend In Revenues Generated By Independent Sales Representatives; Ten Largest Independent
Sales Representatives
9-23. Summary of Factors Impacting Market Share
9-24. Backlog By Product Line Or Service
9-25. Book-To-Ship Ratio
9-26. Schedule of Deliverable Backlog
9-27. Lost Sales; Current or Potential Problem Customers
9-28. Revenue Information Request
9-29. Potential Revenue Improvement Opportunities
9-30. Potential Impact Of An Acquisition On The Combined Revenues
Section 10. Marketing Operations
10-01. Marketing Organization
10-02. Marketing OrganizationResumes Of Key Marketing Personnel
10-03. Compensation Of Key Marketing Staff Personnel
10-04. Qualification, Recruiting And Training Of Direct Sales Personnel
10-05. Compensation Of Direct Sales Personnel
10-06. Marketing OrganizationExpense Accounts
10-07. Marketing Locations And FacilitiesDomestic
10-08. Marketing Locations And FacilitiesForeign
10-09. Marketing Channels
10-10. Distribution ChannelsCharacteristics Of Present System
10-11. Distribution ChannelsMiscellaneous Questions
10-12. Market Planning And ResearchOrganization And Activities
10-13. Market Planning And ResearchMethodology And Expenditures
10-14. Advertising Organization And Activities
10-15. AdvertisingMedia And Expenditures
10-16. Comparison Of Advertising Programs With Major Competitors
10-17. Sales Promotion Organization And Activities
10-18. Trade Show Participation
10-19. Sales Promotion Expense
10-20. Comparison Of Sales Promotion Programs With Major Competitors
10-21. Foreign Marketing Considerations
10-22. Summary Of Franchise OperationsEntity As Franchiser
10-23. Summary Of Franchise OperationsEntity As Franchisee
10-24. Factors Impacting Marketing Activities
10-25. PricingOrganization
10-26. Internal Pricing Policies
10-27. Special Pricing Solutions
10-28. Price Trends
10-29. Current Pricing Environment
10-30. Terms Of Sale And Credit Policies
10-31. Terms Of SaleProduct Warranty And Return Policies
10-32. Terms Of SaleCompetitive Environment
10-33. Product Leasing Programs
10-34. Other Marketing Programs
10-35. Marketing Financial Performance
10-36. Marketing Performance Versus Budget
10-37. Marketing Information Request
10-38. Summary Of Observations Regarding Marketing Activities
10-39. Third Party Comments Regarding Marketing Activities
10-40. Summary Of Major Marketing Strengths And Weaknesses
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10-41. Potential Impact Of An Acquisition On Marketing Organizations


10-42. Potential Impact Of An Acquisition On Outside Marketing Firms
Section 11: Customer Service
11-01: Customer Service Organization
11-02. Resumes Of Key Customer Service Personnel
11-03. Compensation Of Key Customer Service Personnel
11-04. Customer Service Locations
11-05. Trend In Customer Service Staffing; Customer Service Financial Performance
11-06. Customer Service Activities
11-07. Quality Of Customer Service
11-08. Profitability Of Service And Repair Operations
Section 12: Inventory Control And Purchasing
12-01. Inventory Control Organization
12-02. Resumes Of Key Inventory Control Personnel
12-03. Compensation Of Key Inventory Control Personnel
12-04. Inventory Control Activities
12-05. Trend In Inventory Control Staffing; Inventory Control Financial Performance
12-06. Purchasing Organization
12-07. Resumes Of Key Purchasing Personnel
12-08. Compensation Of Key Purchasing Personnel
12-09. Purchasing Activities
12-10. Availability Of Materials And Supplies
12-11. Identification Of Critical Materials And Supplies
12-12. Price Trends For Purchased Materials And Supplies
12-13. Characteristics Of Major Suppliers
12-14. Summary Of Largest Outstanding Purchase Orders
12-15. Summary Of Largest Outstanding Purchase Contracts
12-16. Purchasing Policies And Procedures
12-17. Trend In Purchasing Staffing; Purchasing Department Financial Performance
12-18. Inventory Control And Purchasing Information Request
12-19. Summary Of Observations Of Inventory Control And Purchasing Activities
12-20. Notes Regarding Observations Of Inventory Control Activities
12-21. Notes Regarding Observations Of Purchasing Activities
12-22. Potential Impact Of An Acquisition On Inventory Control Organizations
12-23. Potential Impact Of An Acquisition On Purchasing Organizations
Section 13: Production
13-01. Production Organization
13-02. Resumes Of Key Production Personnel
13-03. Compensation Of Key Production Personnel
13-04. Production Methods And Processes
13-05. Production Facilities
13-06. Production Equipment
13-07. Future Production Equipment Requirements
13-08. Surplus Production Equipment
13-09. Trend In Production Equipment Acquisitions And Accounting Policies With Respect To Major
Equipment Items
13-10. Production Tooling
13-11. Production Capacity And Utilization; Potential Impediments To Nearby Expansion
13-12. Production Planning And Control
13-13. Quality Control
13-14. Stockroom Operations
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13-15. Production Training Programs


13-16. Production Cost Accounting
13-17. Intra-Company Material Transactions
13-18. Subcontracting To Others
13-19. Plant Safety
13-20. Utility Services
13-21. Plant Maintenance
13-22. Trend In Production Staffing
13-23. Production Department Financial Performance
13-24. Trend In Production Productivity
13-25. Competitive Production Environment
13-26. Production Information Request
13-27. Summary Of Observations Regarding Production Activities
13-28. Summary Of Major Production Strengths And Weaknesses
13-29. Potential Impact Of An Acquisition On Production Organization
Section 14: Physical Distribution
14-01. Physical Distribution Organization
14-02. Resumes Of Key Distribution Personnel
14-03. Compensation Of Key Distribution Personnel
14-04. Physical Distribution Activities
14-05. Warehouse Facilities
14-06. Major Distribution Equipment
14-07. Trend In Distribution Equipment Acquisitions; Accounting Policies With Respect To Major
Equipment Items
14-08. Trend In Distribution Staffing; Distribution Financial Performance
14-09. Distribution Of Outbound Transportation By Type Of Carrier; Competitive Distribution
Environment
14-10. Distribution Information Request
14-11. Summary Of Observations Regarding Distribution Activities
14-12. Summary Of Observations Regarding Distribution ActivitiesNotes
14-13. Summary Of Major Distribution Strengths And Weaknesses
14-14. Potential Impact Of An Acquisition On The Distribution Organization
Section 15: Computer, Communications And Information Systems
15-01. Organization Of Computer, Communications And Information Systems
15-02. Resumes Of Key Computer, Communications And Information Systems Personnel
15-03. Compensation Of Key Computer, Communications And Information Systems Personnel
15-04. Computer Applications
15-05. Outside Computer Services
15-06. Planned New Computer Applications
15-07. Computer Inventory
15-08. Communications Applications
15-09. Major Communications EquipmentOther Than Regular Telephones
15-10. Integrated Computer/Communications Systems
15-11. Information Systems
15-12. Integrated Computer/Communications/Information Systems
15-13. Trend In Computer/Communications/Information Systems Staffing
15-14. Trend In Computer/Communications/Information Systems Expenses
15-15. Competitive Computer/Communications/Information Systems Environment
15-16. Computer/Communications/Information Systems Information Request
15-17. Summary Of Observations Regarding Computer/Communications/Information Systems
15-18. Summary Of Computer/Communications/Information Systems Strengths And Weaknesses
15-19. Impact Of An Acquisition On The C. C. & I. Organization
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Section 16: Financial Management


16-01. Financial Organization
16-02. Resumes Of Key Financial Personnel
16-03. Compensation Of Key Financial Personnel
16-04. Accounting Policies And Procedures
16-05. Financial Controls
16-06. Foreign Exchange Transactions
16-07. Internal Audit Function
16-08. Financial Planning And Budgeting
16-09. Financial Reporting
16-10. Financial Activities
16-11. Investor Relations
16-12. Investment Management
16-13. Insurance Management
16-14. Tax Management
16-15. Trend In Finance Department Staffing
16-16. Trend In Finance Department Expenses
16-17. Financial Operations Information Request
16-18. Summary Of Observations Regarding Financial Operations
16-19. Summary Of Financial Strengths And Weaknesses
16-20. Potential Impact Of An Acquisition On The Finance Organization
Section 17: Legal Affairs
17-01. Legal Organization; Compensation Of Key Legal Personnel
17-02. Resumes Of Key Legal Personnel
17-03. Legal Department Activities
17-04. Litigation SummaryEntity Is Plaintiff
17-05. Litigation SummaryEntity Is Defendant
17-06. Potential LitigationEntity Is Plaintiff
17-07. Potential LitigationEntity Is Defendant
17-08. Recently Concluded LitigationEntity Was Plaintiff
17-09. Recently Concluded LitigationEntity Was Defendant
17-10. Patents, Copyrights And Trademarks
17-11. Licensing Agreements
17-12. Regulatory Affairs
17-13. Regulatory Compliance Actions
17-14. Officers And Directors Background Information
17-15. Trend In Legal Department Staffing; Outside Legal Services
17-16. Trend In Legal Department Expenses
17-17. Legal Activities Information Request
17-18. Summary Of Observations Regarding Legal Activities
17-19. Summary Of Major Legal Strengths And Weaknesses
17-20. Potential Impact Of An Acquisition On The Legal Organization
Section 18: Security And Safety
18-01. Security Organization; Safety Organization
18-02. Potential Security Problems
18-03. Potential Safety Problems
18-04. Other Security/Safety Matters
Section 19: Human Resources
19-01. Human Resources Organization; Compensation Of Key Human Resources Personnel
19-02. Resumes Of Key Human Resources Personnel
19-03. Trend In Human Resources Department Staffing; Outside Services
19-04. Trend In Human Resources Department Expenses
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19-05. Distribution Of Personnel By Various Categories


19-06. Benefit Plans For Active Personnel
19-07. Retirement BenefitsPension Plans
19-08. Retirement BenefitsOther Than Pension Plans
19-09. Basic Wage And Salary Factors
19-10. Incentive Programs
19-11. Perquisites; Reimbursement For Relocation Expenses
19-12. Employment Contracts
19-13. Organized Labor Agreements
19-14. Labor-Management Relations
19-15. Hiring Policies And Procedures
19-16. Termination Policies; Termination Benefits
19-17. Training Programs
19-18. Local Labor Environment
19-19. Human Resources Information Request
19-20. Summary Of Observations Regarding Human Resources Activities
19-21. Summary Of Major Human Resources Strengths And Weaknesses
19-22. Potential Impact Of An Acquisition On The Human Resources Organization
19-23. Potential Cost Of Integrating Human Resources Policies
19-24. Estimated Personnel Relocation Expenses
Section 20: Land And Buildings
20-01. Summary Of Active Domestic Facilities
20-02. Summary Of Active Foreign Facilities
20-03. Physical Characteristics Of Active Facilities
20-04. Financial Characteristics Of Owned Facilities
20-05. Financial Characteristics Of Leased Facilities
20-06. Miscellaneous Facility Characteristics
20-07. Factors Potentially Impacting The Future Value Of Existing Facilities
20-08. Production Capacity And Potential Modifications To Existing Facilities
20-09. Summary Of Currently Inactive Facilities; Potential Retirement Of Currently Active Facilities
20-10. Summary Of Undeveloped Land; Trend In Real Property Taxes
20-11. Potential Acquisition Of New Facilities
20-12. Property And Facilities Information Request
Section 21: Introduction To Financial Analyses
21-01. Summary Balance Sheet As Of ______
21-02. Summary Income Statement For The _______
Section 22: Balance Sheet AnalysisLiabilities
22-01. Short-Term Notes Payable
22-02. Short-Term Debt Service Payments; Principal Balances Of Short-Term Debt
22-03. Payable Aging For The Twenty-Five Largest Accounts
22-04. Explanation For Overdue Payables
22-05. Accounts Payable Analysis
22-06. Trend In Unearned Revenues; Trend In Accrued Expenses
22-07. Trend In Total Current Liabilities
22-08. Long-Term Notes Payable
22-09. Features of Bond Issues
22-10. Long-Term Debt Service Payments; Principal Balances Of Long-Term Debt
22-11. Recent Bond Performance
22-12. Other Noncurrent Liabilities
Section 23: Revenues
23-01. Trend In Gross Revenues, Revenue Reductions, And Net Revenues
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Section 24: Operating Expenses


24-01. Selling Expenses
24-02. Selling Expenses As A Percent Of Net Revenues
24-03. Variation In Selling Expense With Net Revenues
24-04. Comparison Of Selling Expenses As A Percent Of Net Revenues
24-05. General And Administration Expenses
24-06. General And Administration Expenses As A Percent Of Net Revenues
24-07. Variation In General And Administrative Expenses With Net Revenues
24-08. Comparison Of General And Administrative Expenses As A Percent Of Net Revenues
24-09. Allocation Of Office Occupancy And Office Equipment And Furniture Expenses
24-10. Payroll Related Expenses As A Percent Of Payroll Expenses
24-11. Comparison Of Payroll Related Expenses As A Percent Of Payroll Expenses
Section 25: Income Taxes
25-01. Status Of Income Tax Filings And Audits; Provision For Income Taxes
25-02. Elements Of Deferred Taxes; Effective Tax Rate
25-03. Availability Of Net Operating Loss; Deficiency Claim Settlements
25-04. Income Tax Information Request
Section 26: Net Income
26-01. Trend In Net Income; Comparison Of Profit Margin With Industry Averages And With Selected
Companies
Section 27: Capital Expenditures
27-01. Trend In Capital Expenditures; Comparison With Depreciation Expense And Net Revenues
27-02. Trend In Adjusted Capital Expenditures; Comparison Of Adjusted Capital Expenditures With Net
Revenues
Section 28: Cash Flow
28-01. Trend In Cash Flow
Section 29: Financial Ratio Analysis
29-01. Profitability Ratios
29-02. Stock Performance Ratios
29-03. Liquidity Measures
29-04. Debt Ratios
29-05. Activity Ratios
29-06. Trend In Profitability Ratios
29-07. Trend In Common Stock Performance Ratios
29-08. Trend In Liquidity Measures
29-09. Trend In Debt Ratios
29-10. Trend In Activity Ratios
Section 30: Income Statement Projections
30-01. Projection Of Gross And Net Revenues
30-02. Projection Of Cost Of Goods Sold And Gross Margin
30-03. Projection Of Selling Expenses
30-04. Projection Of General And Administrative Expenses
30-05. Projection Of Selling, General And Administrative Expenses
30-06. Projection Of Operating Income
30-07. Projection Of Other Income And Expenses
30-08. Projection Of Unusual And Infrequent Items
30-09. Projection Of Unusual, Infrequent And Extraordinary Items
30-10. Basis For Projections Of Unusual, Infrequent And Extraordinary Items

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30-11. Projection Of Net Income


30-12. Comparison Of Entitys And Investigators Projections
Section 31: Balance Sheet Projections
31-01. Projection Of Current Asset Requirements
31-02. Projection Of Property, Plant And Equipment
31-03. Projection Of Other Noncurrent Assets
31-04. Projection Of Short-Term Debt
31-05. Projection Of Accounts Payable
31-06. Projection Of Unearned Revenues And Accrued Expenses
31-07. Projection Of Other Noncurrent Liabilities
31-08. Projection Of Shareholders Equity Other Than Retained Earnings
31-09. Projection Of Change In Retained Earnings
31-10. Summary Balance Sheet Form
Section 32: Cash Flow Projections
32-01. Projections Of Cash Flow
32-02. Monthly Debt Service Payments On Current Short-Term Notes Payable And Current Portion of
Long-Term Debt
32-03. Annual Debt Service Payments Based On Current Debt
CHECKLISTS AND OTHER DOCUMENTS
Section 33: Due Diligence Checklists For Acquisitions Or Investments
Or Specific Dealings In Selected Industries
33-01: Restaurant Businesses
33-02: Franchising Companies
33-03. Hospitals And Health Care Facilities
33-04. Technology-Driven Companies
33-05. Outsourcing Technological Services
33-06. Private Equity And Hedge Funds
33-07. Family And Closely-Held Businesses
Section 34: Transaction-Specific Due Diligence Checklists
34-01. Due Diligence Checklists For Joint Ventures/Strategic Alliances
34-02. Due Diligence Checklists For Technology Licensing Arrangement
34-03. Due Diligence Checklists For Dealership & Distributorship Arrangement
Section 35: Sample Forms Related To Effective Due Diligence
35-01. Confidentiality Agreement
35-02. Investor Questionnaire In Connection With Private Placement Offerings
35-03. Officer And Director (Employee & Non-Employee) Questionnaire To Conduct Due Diligence
Of Existing Board Members Prior To An Offering Or In Connection With An M&A Transaction
Section 36: Due Diligence Checklists For Special Situations
36-01. Employee Benefit Plans And ERISA Matters
36-02. Hart-Scott-Rodino Questionnaire (Antitrust Compliance Filings)
36-03. Environmental Matters
36-04. Real Estate And REIT Matters

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SECTION 1
PREFACE
CONTENTS

SUBJECT

TEXT

Whats New In This Edition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3


What Is Due Diligence? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Overview: The Art And Science Of Due Diligence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Why Is Due Diligence Necessary?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Common Due Diligence Problems And Exposure Areas . . . . . . . . . . . . . . . . . . . . . . . . . 7
Common Mistakes Made By The Buyer During The Due Diligence Investigation . . . . . 7
Special Due Diligence Considerations In A Post Sarbanes-Oxley Age. . . . . . . . . . . . . . . 8
The Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Checklist Of Items Post Sarbox . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Some Useful Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

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SECTION 1
PREFACE

WHATS NEW IN THIS EDITION


In wake of the Sarbanes-Oxley Act enacted pursuant to the Enron scandal and subsequent events as well as
the changed Mergers and Acquisitions scenario due to the credit crisis, a significant change has been witnessed in the practice of due diligence. This has necessitated addition of content in the introductory sections
of the Handbook, including common due diligence problems, common mistakes made by the buyer and the
art and science of due diligence that prominently reflect the practice of due diligence in current times.
Due diligence practice post Sarbanes-Oxley enactment deserves the addition of a separate section in view of
some onerous disclosure requirements that are now mandatory. An additional section has been inserted providing checklists for potential acquisitions or investment in selected industries and/or businesses. Such
checklists are provided with a view to educate audiences of special considerations in each of the businesses
contained in that section to facilitate a unique due diligence process for each such business. Examples of such
businesses include restaurant services, franchising companies, hospitals, outsourcing technical services, private equity and hedge funds and closely held businesses. With each such business, we seek to cater to a broad
audience of the new series of the Handbook to give useful insights on warning signals before investing or
acquiring such specific businesses.
The section on Non-M&A transactions has been added with an aim to make the new series of the Handbook
comprehensive. Adequate and timely due diligence is required not just for transactions that pertain to acquisition or investment, but to joint ventures, strategic alliances, licensing technology and entering into dealership or distributorship agreements. Continuing on our intention to cater to a broad audience, the editors of the
Handbook seek to leverage on their practical and legal experience in such individualized transactions and provide effective checklists to ensure that potential participants of such transactions are in safe harbor before
signing on dotted lines of formal instruments.

WHAT IS DUE DILIGENCE?


Due diligence is a process whereby an individual, or an organization, seeks sufficient information about a
business entity to reach an informed judgement as to its value for a specific purpose.
Situations Calling For Due Diligence
Due diligence is performed in a wide variety of situations, e.g.:

By a firm considering a potential acquisition.


By an investment banker considering underwriting a public security offering or promoting a
private placement.

By a banker considering the making of a loan.


By a venture capitalist considering an investment.
By a lawyer preparing an offering statement or a merger proposal for a client.
By an appraiser who has been retained to estimate the value of a business unit.
By a business broker offering a company for sale.

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Situations Calling For Due Diligence (Continued)

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.

By a security analyst preparing a buy, hold or sell recommendation on a public security.


The due diligence investigation is normally carried out with the knowledge and cooperation of the management of the entity being investigated.
The Due Diligence Investigation Is Not, By Itself, An Audit
A due diligence investigation may include a detailed audit. However, it is not, in itself, an audit in the manner normally conducted by a public accounting firm.
The due diligence investigation is much broader than an audit.

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.

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OVERVIEW: THE ART AND SCIENCE OF DUE DILIGENCE


Due diligence is not just a process, it is also a reality testa test of whether the factors driving the deal and
making it look attractive to the parties are real or illusory. Due diligence is not a quest to find the deal-breakers
but a test of the value proposition underlying the transaction to make sure that the inside of the house is as
attractive as the outside. Once the foundation has been dissected, it can either be rebuilt around a deal that
makes sense or allow the buyer to walk away and prevent the consummation of a deal that doesnt make sense.
Overall, the due diligence process, when done properly, can be tedious, frustrating, time-consuming, and
expensive. Yet it is a necessary prerequisite to a well-planned acquisition, and it can be quite informative and
revealing in its analysis of the target company and its measures of the costs and risks associated with the transaction. Buyers should resist the temptation to conduct a hasty once over, either to save costs or to appease
the seller. Yet at the same time, they should avoid due diligence overkill, keeping in mind that due diligence
is not a perfect process and should not be a tedious fishing expedition. Like any audit, a diligence process is
designed to answer the important questions, and ensure with reasonable assurance that the sellers claims
about the business are fair and legitimate.

Proper due diligence involves:


Knowing where to look
Knowing what to ask
Knowing what tools to use
Knowing who to ask
Knowing how to test premises/answers
Knowing who should ask
Effective due diligence is both an art and a science.
The art is the style and experience to know which questions to ask and how and when to ask them. Its the ability to create an atmosphere of both trust and fear in the seller, which encourages full and complete disclosure.
In this sense, the due diligence team is on a risk discovery and assessment mission, looking for potential problems and liabilities (the search), and finding ways to resolve these problems prior to closing and/or to ensure
that risks are allocated fairly and openly after the closing.

The Art of Due Diligence:


Understanding how to extract key information from a person or situation
Understanding the objectives of the parties and the underlying transaction
Identifying key hurdles and risks
Identifying why information might be falsified or omitted
Targeting the proper sources for disclosure of information
The science of due diligence is in the preparation of comprehensive and customized checklists of the specific questions to be presented to the seller, in maintaining a methodical system for organizing and analyzing the
documents and data provided by the seller, and in quantitatively assessing the risks raised by those problems
discovered in the process.

The Science of Due Diligence:


Do your homework
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OVERVIEW: THE ART AND SCIENCE OF DUE DILIGENCE (Continued)

Be prepared and well-organized


Be precise in your requests
Be persistent in your quest for the truth
Dont accept the first answer as the final answer

WHY IS DUE DILIGENCE NECESSARY?


Poor Record Of Performance
Lack of adequate due diligence is a major cause of the poor financial performances experienced by many of
Americas industrial corporations and financial institutions.
Re: Acquisitions
Nowhere is the lack of adequate due diligence more evident than in the area of corporate acquisitions and
mergers.
It is estimated that only 15 to 20 percent of these transactions live up to their expectations. Twenty-five to 30
percent are reported to be downright failures - with the acquired entity being resold or liquidated at a loss
within three to five years. The remaining 40 to 50 percent have resulted in little or no apparent benefit to the
buyers shareholders.
Re: Leveraged Buyouts
The business press has gone on at length regarding the inevitability that the excessive leverage built into many
of the LBOs of the 1980s would result in large scale reorganizations in the 1990s.
Re: Public Security Offerings
With some notable exceptions, the track record of recent public offerings has not lived up to expectations.
Re: Bank Loans
The recent writeoffs of bad loans has had a significant impact on the reported earnings of some of Americas
most respected banks and savings and loan institutions.
Re: Venture Capital Investments
Venture capitalists frequently indicate that their objective is to make enough money from the successful 20 to
30 percent of their deals to more than compensate for the losses they experience on the unsuccessful ones.
Re: Insurance Companies
Several large insurance companies experienced financial difficulties due to investments in corporate securities that were deemed to have too high a risk by firms that performed more extensive due diligence.

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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.

COMMON DUE DILIGENCE PROBLEMS AND EXPOSURE AREAS


There are virtually an infinite number of potential problems and exposure areas for the buyer which may be
uncovered in the review and analysis of the sellers documents and operations. The specific issues and problems will vary based on the size of the seller, the nature of its business and the number of years that the seller (or its predecessors) have been in business.

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.

The possibility of environmental liability under CERCLA or related environmental regulations.


Unresolved existing or potential litigation these cases should be reviewed carefully by counsel.
A sellers attempt to dress-up the financial statements prior to sale, often in an attempt to hide
inventory problems, research and development expenditures, excessive overhead and administrative costs, uncollected or uncollectible accounts receivable, unnecessary or inappropriate personal
expenses, unrecorded liabilities, tax contingencies, etc.

COMMON MISTAKES MADE BY THE BUYER DURING


THE DUE DILIGENCE INVESTIGATION
1. Mismatch between the documents provided by the seller and the skills of the buyers review team.
It may be the case that the seller has particularly complex financial statements or highly technical
reports which must be truly understood by the buyers due diligence team. Make sure there is a
capability fit.
2. Poor communication and misunderstandings. The communications should be open and clear
between the teams of the buyer and the seller. The process must be well orchestrated.

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COMMON MISTAKES MADE BY THE BUYER DURING
THE DUE DILIGENCE INVESTIGATION (Continued)
3. Lack of planning and focus in the preparation of the due diligence questionnaires and in the interviews with the sellers team. The focus must be on asking the right questions, not just a lot of questions. Sellers will resent wasteful fishing expeditions when the buyers team is unfocused.
4. Inadequate time devoted to tax and financial matters. The buyers (and sellers) CFO and CPA
must play an integral part in the due diligence process in order to gather data on past financial performance and tax reporting, unusual financial events or disturbing trends or inefficiencies.
5. Lack of reasonable accommodations and support for the buyers due diligence team. The buyer
must insist that its team will be treated like welcome guests, not enemies from the IRS! Many
times buyers counsel is sent to a dark room in the corner of the building to inspect documents
without coffee, windows or phones. It will enhance and expedite the transaction if the seller provides reasonable accommodations and support for the buyers due diligence team.
6. Ignoring the real story behind the numbers. The buyer and its team must dig deep into the financial data and test (and retest) the value proposition as to whether the deal truly makes sense. They
must ask themselves, Does the real value truly justify the price? The economics of the deal may
not hold water once a realistic look at cost allocation, inventory turnover, and capacity utilization
is taken into account.

SPECIAL DUE DILIGENCE CONSIDERATIONS IN A POST


SARBANES-OXLEY AGE
In the 1990s, acquirers rarely had the opportunity to conduct extensive, time-consuming due diligence. Buyers
were seldom granted exclusivity periods, and the typical auction may have allowed the potential buyer only
a day or two in the data room (which sometimes had a no-copy rule) and a few hours of management interviews. After the Enron scandal and a few others hit the American corporate world, the Public Company
Accounting Reform and Investor Protection Act of 2002, also known as Sarbanes-Oxley Act (Sarbox) was
enacted which changed the way businesses were conducted and corporate governance was practiced.
Sarbox lays out a government-mandated disclosure process that is monitored by auditors, certified by toplevel executives under penalty of prison and reviewed by the SEC. It addresses corporate responsibility, the
creation of a public company accounting oversight board, auditor independence and enhanced criminal sanctions. The effect of Sarbox has been to compel investment banks, regulators, shareholder groups, plaintiff
lawyers and other parties to now analyze companies with a focus on the broad mandates of Sarbox
Sarbox does not apply only to large publicly traded corporations; privately held companies can also be subject to Sarbox. Lenders and customers can each require a company to adopt Sarbox-style procedures. A companys accountants and D&O insurance carriers can also prompt a company to do it.

THE DISCLOSURE REQUIREMENTS


Potential acquirers must be aware of the main federal corporate disclosure requirements: Regulation S-K,
FASB No. 5, and Sarbox
I. Regulation S-K issued by the SEC acts as an instruction manual for public companies filing their annual,
quarterly and interim reports. The important provisions are as under:

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THE DISCLOSURE REQUIREMENTS (Continued)


a) Item 101 requires reporting companies to describe their businesses, products and competition as well
as report on their financial position by industry segments. Companies must discuss transactions outside of the ordinary course, R&D activities, intellectual property, backlog, foreign operations and the
anticipated costs and effects of environmental compliance both current and projected.
b) Item 103 calls for companies to disclose any large nonroutine legal proceedings to which they are
a party, and even some routine matters that exceed certain thresholds. Also, Item 303 requires a
companys management to discuss known trends, events and uncertainties that could have a material effect on its business
c) Item 402 call for a detailed review of the companys executive compensation, employee contracts,
benefits, options and so on.
d) Item 404 focuses on related party transactions. Material contracts are to be included as exhibits to
the periodic filings, so, many times, credit agreements, joint venture agreements, even real estate
leases are on the public record.
II. Statement of Financial Accounting Standards No. 5: Accounting for Contingencies, issued by the
Financial Accounting Standards Board, deals with disclosing loss contingencies. Observing FASB No.
5 is part of complying with generally accepted accounting principles, and is a key element in the audit
letter process. It requires a company to establish a loss contingency in its financial statements if
(1) available information indicates that it is probable that the company has suffered a loss, and
(2) the amount of that loss can be reasonably estimated.
III. Sarbox introduces stringent disclosure requirements for companies. The main disclosure requirements a
potential acquirer must have in mind are as under:
a) Section 302 of Sarbox requires the chief executive officer and the chief financial officer of a company to personally certify certain items about the annual or quarterly report being filed. In summary, they must certify that

they have read the report,


the report fairly presents the companys financial condition and results of operations,
to their knowledge, the report contains no untrue statements or omissions of material fact that
would make the statements misleading, and

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:
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THE DISCLOSURE REQUIREMENTS (Continued)

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.
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THE DISCLOSURE REQUIREMENTS (Continued)


e) GAAP practices often allow for discretion, and to the extent that the targets accounting practices
differ from the buyers, the differences need to be harmonized. The buyer should recognize the
potential impact this may have on the combined companys earnings. For example, buyers should
pay attention to the targets policies for accounting for contingent liabilities. If the buyers
accounting practices are more conservative (i.e., will result in greater reserves), the impact must
be understood and taken into account in the buyers evaluation.

CHECKLIST OF ITEMS POST SARBOX


Thus, Sarbox and the SEC rules promulgated thereunder have profoundly affected important aspects of M&A
practice in a number of ways, including the nature and scope of the due-diligence process and the terms and
conditions under which the transaction is effected. In conducting due diligence and in crafting appropriate representations and warranties in deal documents particularly with respect to closing conditions and material
adverse effect or change (MAE or MAC) clauses public company buyers must consider the following
Sarbox-related items:
I. Does the seller maintain effective disclosure controls and procedures?

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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CHECKLIST OF ITEMS POST SARBOX (Continued)

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

DUE DILIGENCE HANDBOOK

1-11

CHECKLIST OF ITEMS POST SARBOX (Continued)

Are there any loans or extensions of credit to the sellers executive officers and directors in violation of Section 402 of Sarbox?

SOME USEFUL DEFINITIONS


Several terms have been used throughout the Handbook that require explanation.

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.

As used herein, an investigator may be an individual or a member of an investigation team.


He or she may be an employee of the company exploring a potential acquisition, an outside
lawyer, an investment banker or accountant assisting a client in a potential acquisition or
security offering, an appraiser retained to provide an evaluation of an entity, or any other person participating in a due diligence investigation.

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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DUE DILIGENCE HANDBOOK

2-00
SECTION 2

HOW TO USE THE DUE DILIGENCE HANDBOOK


CONTENTS
SUBJECT

TEXT

Master Copy / Files On CD. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17


Page NumberingText And Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Use Of Header Block On Form Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Use Of Footer Block On Form Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Suggestions For Conducting The Due Diligence Investigation . . . . . . . . . . . . . . . . . . . . 19

15

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DUE DILIGENCE HANDBOOK

2-01
SECTION 2

HOW TO USE THE DUE DILIGENCE HANDBOOK


MASTER COPY / Files On CD
All forms in this handbook are available as customizable Word documents. They are on the CD provided in
the back of the book. It is recommended that these files be considered as a Master Copy. Immediately upon
receipt of the handbook, one or more working copies of the files for the forms should be made and the
master files stored on a back-up drive filed in a secure location.
This will avoid having to order new masters should someone inadvertently use or misplace an original form.
As a reminder, neither the original purchased copy nor any copies of this copyrighted document are to be sold,
loaned, given, or otherwise made available to a person or organization unrelated to the original purchaser, or
to a related person or organization located at a different site, without the written permission of the publisher.

PAGE NUMBERINGTEXT And FORMS


Within each numbered section the introductory text pages come first, followed by the blank forms.
Section 1 is the Preface and Section 2 describes in detail how to use this handbook.
* The Preface points out what is new in this edition, gives an overview of due diligence, lists common mistakes made by the buyer during due diligence, and enumerates the main disclosure requirements mandated by federal regulations.
* Section 2 details how to use the book during the due diligence process and points out specific uses
of the forms that begin in Section 3.
The forms begin in Section 3. Each section includes introductory text, where the reader will find a description of the forms and their use.
Each section also has its own Table of Contents.
* The page numbers under "Text" refer to the page numbers on the bottom of each page of the handbook. They list the pages in the introductory text on which particular topics and the forms related
to each topic are discussed.
* The Form numbers are listed in the column to the right.

USE OF HEADER BLOCK ON FORM SHEETS


The name of the entity being investigated may be entered on the top line. As noted in the definitions provided in Section One, this may be a company, a division or subsidiary of a company, or a product line.
The use of the footer block, extending across the bottom of the form sheets is described on the following page.

17

2-02

DUE DILIGENCE HANDBOOK


USE OF FOOTER BLOCK ON FORM SHEETS

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.

To indicate a project number.


To indicate the priority for completing the forms, e.g.: A, B, C, . . . . etc.; or A-l, A-2, .
. . . etc.
Use Of Prepared By Box
The Prepared By box should contain the name or initials of the person primarily responsible for completing the form.
This will facilitate locating the originator of the form in the event a question arises regarding information
provided therein.

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.

18

DUE DILIGENCE HANDBOOK

2-03

SUGGESTIONS FOR CONDUCTING THE DUE DILIGENCE INVESTIGATION


The due diligence process has been likened to peeling a blemished onion. You investigate one layer at a time.
Each phase of the investigation uncovers additional items to be explored further. You then move on to the next
phase - and the next - until you reach a conclusion as to whether to continue or to abandon the investigation.
The keys to an efficient investigation are to bring together a team of qualified, professionally oriented individuals, to determinine the depth of information required and to establish priorities for its collection.
The Team Approach
It is rare to find one, or even two people, who have the breath of knowledge to carry out a thorough due diligence investigation - particularly if time is of the essence, as it always seems to be.
If the team approach is adopted it should consist of individuals with the right combination of experience and
professionalism suitable to the task.
Breath And Depth Of Information Required
The objectives of the investigation will determine the breath and depth of information required.

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.

19

2-04

DUE DILIGENCE HANDBOOK


Periodic Review Meetings

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:

To obtain status reports from the Team members on their progress.


To determine when it becomes appropriate to redirect, cancel or otherwise change the course of
the investigation.

To determine whether it is appropriate to assign additional personnel to accelerate the effort.


To determine if it is timely to bring in outside expertise. For example, if tax or pension plan experts
have not been part of the original Team, is it now time to obtain their assistance?

When is it appropriate to formalize the results of the investigation in a report to the appropriate
level of management?

20

DUE DILIGENCE HANDBOOK

3-00
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

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DUE DILIGENCE HANDBOOK

3-01
SECTION 3

OVERVIEW OF INDUSTRY AND ENTITY


Introduction
This section, when completed, will provide information that is ordinarily found in the Executive
Summary section of a Business Plan, Descriptive Memorandum, Offering Circular or similar document.
The objective is to provide the reader with a quick overview of the entity undergoing the due diligence
investigation. All of the data summarized herein will appear in greater detail in the appropriate sections of
the Handbook.
The level and extent of this general business and strategic due diligence will vary, depending on the experience of the buyer in the sellers industry and its familiarity with the seller company. For example, a financial
buyer entering into a new industry and with no prior experience with the seller should conduct an exhaustive
due diligence not only on the sellers company but also on any relevant trends within the industry that might
directly or indirectly affect the deal. In contrast, a management buyout by a group of industry veterans who
have been with the seller over an extended period of time will probably need to conduct only a minimum
amount of business or strategic due diligence; in this case, the focus will be on legal due diligence and assessment and assumption of risk.
Therefore, for a buyer getting to know the sellers industry, the following two basic questions must be asked:
1) How would you define the market or markets in which the seller operates? What steps will you take
to expedite your learning curve of trends within these markets? What third-party advisors are qualified to advise you on key trends affecting this industry?
2) What are the factors that determine success or failure within this industry? How does the seller stack
up? What are the image and reputation of the seller within the industry? Does it have a niche? Is the
sellers market share increasing or decreasing? Why? What steps can be taken to enhance or reverse
these trends?
Background Information On Entity - Form 3-01
Form 3-01 will provide the information necessary to properly identify the entity, the principal officers and the
parent company if the entity is not a stand-alone operation.
The second page of Form 3-01 will identify the major sources of revenue, the estimated market share held by
the entity and the major competitors.
Space is also provided to list significant events that have impacted the entitys growth and/or financial
performance.
Financial Summary - Form 3-02
This summary, when completed, will provide an overview of the entitys financial performance over the past
five years.

23

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ENTITY

Form 3-01

BACKGROUND INFORMATION ON ENTITY


HEADQUARTERS INFORMATION
STREET/SUITE
CITY/STATE/ZIP
PHONE

FAX

IDENTIFICATION NUMBERS
FEDERAL I.D. NO.

STATE I.D. NO.

DUNS NO.

FORM OF ORGANIZATION (1)


PARENT COMPANY (IF APPLICABLE)
Note: (1) Examples: public corporation, subsidiary of public corporation, division of public corporation, private
corporation, partnership, unincorporated entity, etc.

TOP MANAGEMENT
CHAIRMAN

PRESIDENT

C.E.O.

C.F.O.

STATES IN WHICH ENTITY IS LEGALLY QUALIFIED TO DO BUSINESS

[ ] All 50 States [ ] All except: ______________________________________________________________ .


[ ] Specifically: ___________________________________________________________________________ .

FOREIGN COUNTRIES IN WHICH ENTITY CURRENTLY DOES BUSINESS

REF.

PREPARED BY

REVIEWED BY

25

REVISION

DATE

SECTION

PAGE

ENTITY

Form 3-01

BACKGROUND INFORMATION (Continued)


PRODUCT LINE / SERVICE SUMMARY (1)
PRODUCT LINE / SERVICE

NET
REVENUE
($000)

PERCENT
OF TOTAL
NET
REVENUE

ESTIMATED
MARKET
SHARE

MAJOR COMPETITORS

Total - Above Revenues

Total - Entity Revenues

100.0%

Note: (1) Most recent twelve months ending _____________ . Array in descending order of net revenues.

CHRONOLOGY OF SIGNIFICANT EVENTS

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

PERCENTAGE CHANGE FROM PREVIOUS YEAR


YEAR

NET REVENUE

20

PRETAX INCOME

NET INCOME

20
20
20
20

PRETAX RETURN ON AVERAGE EQUITY


YEAR

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

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DUE DILIGENCE HANDBOOK

4-00
SECTION 4

COMPATIBILITY WITH INVESTMENT/ACQUISITION OBJECTIVES


CONTENTS
SUBJECT

TEXT

FORMS

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Compatibility With Investment/Acquisition Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Form 4-01

Compatibility With Investment/Acquisition Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Form 4-02

Potential Impact Of External Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Form 4-03

Potential Benefits From Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Form 4-04

Potential Impact Of Locational Factors On A Prospective Investment . . . . . . . . . . . . . . . . . 32

Form 4-05

Characteristics You May Wish To Avoid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Form 4-06

Why Is The Entity Available? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Form 4-07

Comparison With Other Potential Investment/Acquisition Candidates . . . . . . . . . . . . . . 33

Form 4-08

29

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DUE DILIGENCE HANDBOOK

4-01
SECTION 4

COMPATIBILITY WITH INVESTMENT OBJECTIVES


Introduction
The material requested in this section will be of primary interest to individuals or organizations that are contemplating, or in some way participating in, a potential investment in the entity, e.g.:

A company or individual contemplating the potential acquisition of the entity.


An investment banker preparing for a public offering or private placement of the entitys securities.
A security analyst preparing an evaluation of the potential future trend in the value of the entitys
securities.

A commercial banker or insurance company evaluating a loan request.


An appraisal firm establishing the fair market value of the entity for estate planning purposes or as
the basis for a buy/sell agreement among business partners.
While the reasons for performing a due diligence investigation are diverse, the beneficiaries of the investigation have a common question:
HOW WELL DOES AN INVESTMENT IN THE ENTITY MEET MY,
OR MY CLIENTS, OBJECTIVES?
The information requests in this section are intended to provide an initial, nonanalytical, screening mechanism.
If the responses to the questions posed here indicate a basic incompatibility with the investors objectives,
there is no point in pursuing the investment further.

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.

31

4-02

DUE DILIGENCE HANDBOOK


Potential Impact Of External Factors - Form 4-03

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

DUE DILIGENCE HANDBOOK

4-03

Comparison With Other Potential Investment/Acquisition Candidates - Form 4-08


One of the most critical due diligence skills in the ability to compare/contrast investment or transactional
opportunities which as similarly situated or which may offer difficult but equally compelling features. This
checklists with this analytical process.

33

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ENTITY

Form 4-01

COMPATIBILITY WITH INVESTMENT/ACQUISITION OBJECTIVES


INDUSTRY/BUSINESS PREFERENCES

Ranking system: (1) Highly desirable.

RANK

(2) Desirable.

ENTITY FIT

(3) Open to consideration.

CHARACTERISTICS DESIRED

RANK

ENTITY FIT

Management will stay.


Effective management style.
Depth of management.
Long product life cycle.
Noncyclical.
Little or no seasonal variation.
Not capital intensive.
Not energy intensive.
Not labor intensive.
Nonunion work force.
Low technology.
High technology.
Good product/service reputation.
Minimum market share(s) of _________ %.
No dominant competitors.
State-of-the-art facilities and equipment.
Minimal environmental impact.

Ranking system: (1) Essential.

REF.

PREPARED BY

(2) Desirable.

(3) Not important.

REVIEWED BY

35

REVISION

DATE

SECTION

PAGE

ENTITY

Form 4-02

COMPATIBILITY WITH INVESTMENT/ACQUISITION CRITERIA


CRITERIA

VALUES SOUGHT

ENTITY

(Dollars In Thousands)
Range Of Investment

$ __________________ To $ __________________

Potential Three Year Appreciation In


Common Stock Price

Minimum Of _______ %

Dividend Return On Common


Shares

Minimum Of _______ %

Coupon Rate On Preferred Shares

Minimum Of _______ %

Interest Rate On Straight Bonds

Minimum Of _______ %

Interest Rate On Convertible Bonds

Minimum Of _______ %

Annual Net Revenue

Minimum Of $ __________________

Five Year Average Revenue Growth


Annual Pretax Income

Minimum Of _______ %
Minimum Of $ __________________

Five Year Average Pretax Income


Growth

Minimum Of _______ %

Pretax Return On Net Revenues

Minimum Of _______ %

Pretax Return On Assets

Minimum Of _______ %

Pretax Return On Net Worth

Minimum Of _______ %

Pretax Return On Investment

Minimum Of _______ %

Debt/Equity Ratio

No Greater Than _______ %

Price/Pretax Earnings Ratio

Maximum Of _______ : 1

Premium Above Net Worth

Maximum Of _______ %

REF.

PREPARED BY

REVIEWED BY

36

REVISION

DATE

SECTION

PAGE

ENTITY

Form 4-03

POTENTIAL IMPACT OF EXTERNAL FACTORS


POTENTIAL BENEFIT

NO
IMPACT

NEGATIVE

SOMEWHAT
POSITIVE

VERY
POSITIVE

SECTION

PAGE

FOREIGN GEOPOLITICAL FACTORS


Continued conflict in the Middle East
Improvement In relations with Russia
Terrorism
Expansion of NATO
Increasing importance of Pacific Rim countries:
In international trade
In political influence
Integration of the European common market
Strength of euro
Growth of Indian economy
Continued growth of Asian imports to U.S.
Growth of China market
Continued growth of Chinese imports to U.S.
Potential change in relations with Cuba
North American Free Trade Agreement - NAFTA
Global Financial Crises
Increasing foreign investment in U.S. industry
Increasing foreign competition
Privatization of previously government owned activities

REF.

PREPARED BY

REVIEWED BY

37

REVISION

DATE

ENTITY

Form 4-03

POTENTIAL IMPACT OF EXTERNAL FACTORS (Continued)


POTENTIAL BENEFIT

NO
IMPACT

NEGATIVE

SOMEWHAT
POSITIVE

VERY
POSITIVE

MAJOR DOMESTIC ECONOMIC AND DEMOGRAPHIC FACTORS


Changing age distribution of the U.S. population
Population movement toward sunbelt regions
Business relocation away from congested urban areas
Increasing participation of women in government,
management and the professions
Increasing number of two-wage-earner families
Increasing home employment opportunities
Increasing requirement for child day care facilities
Increasing cost of medical procedures
Increasing trend toward telecommuting
Legislation re balancing the budget
Legislation re health-care reform
Legislation re improving education
Increasing energy costs
Increasingly stringent environmental regulations
Increasing highway congestion
Increasing waste disposal problems

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

POTENTIAL BENEFITS FROM ACQUISITION


POTENTIAL BENEFIT

NO
IMPACT

NEGATIVE

SOMEWHAT
POSITIVE

VERY
POSITIVE

POTENTIAL ADMINISTRATIVE BENEFITS


Source of needed management skills
Improves age distribution of management staff
Improves depth of management
Enhances individual managers growth opportunities
Permits consolidation of management functions
POTENTIAL DATA PROCESSING BENEFITS
Increases utilization of existing facilities
Justifies acquisition of more powerful system(s)
Permits sale of surplus equipment
POTENTIAL MARKETING BENEFITS
Eliminates a competitor
Improves competitive position
Improves market share
Expands products/services offered to existing customer
base
Expands customer base
Extends geographic boundaries of market - Domestic
Extends geographic boundaries of market - Foreign
Reduces volitility of sales due to economic conditions
Reduces seasonal variation in sales
Reduces impact of inflation
Permits replacement of obsolete and/or slow growth
products or services
Reduces dependency on sales to the defense industry
Reduces dependency on sales to other government
agencies
Permits consolidation of sales facilities
Permits consolidation of sales personnel
Gains valuable patents, copyrights and/or trademarks

REF.

PREPARED BY

REVIEWED BY

39

REVISION

DATE

SECTION

PAGE

ENTITY

Form 4-04

POTENTIAL BENEFITS FROM ACQUISITION (Continued)


POTENTIAL BENEFIT

NO
IMPACT

NEGATIVE

SOMEWHAT
POSITIVE

VERY
POSITIVE

POTENTIAL FINANCIAL BENEFITS


Increase growth in earnings
Increase earnings per share:
Immediate post acquisition
Near term expectation
Improve earnings ratios:
Return on equity
Return on assets
Return on sales
Improve stability of revenues and earnings
Reduce seasonal variation in revenues and earnings
Increase cash flow
Enhance cash position from sale of surplus assets
Improve debt/equity ratio
Enhance borrowing capacity
Potential for upgrading undervalued assets
Sale of underperforming activities
Utilization of tax loss carry forwards
Improve credit standing with suppliers
Improve credit rating of debt securities
Improve market valuation of equity securities
Improve price/earnings ratio of shares
Obtain listing on public exchange:
To provide liquidity for existing shareholders
To have vehicle for future public offerings
To provide shares for subsequent acquisitions
To broaden ownership in Company
Qualify for listing on higher level exchange
Reduce ownership of major existing shareholder(s)

REF.

PREPARED BY

REVIEWED BY

40

REVISION

DATE

SECTION

PAGE

ENTITY

Form 4-04

POTENTIAL BENEFITS FROM ACQUISITION (Continued)


POTENTIAL BENEFIT

NO
NEGATIVE
IMPACT

SOMEWHAT
POSITIVE

VERY
POSITIVE

SECTION

PAGE

POTENTIAL PRODUCTION BENEFITS


Utilization of excess capacity
Obtains needed additional capacity
Increased volume provides economies of scale
Obtains advanced production skills and/or equipment
Justifies purchase of advanced state-of-the-art
equipment
Retirement of obsolete facilities and/or equipment
Increased volume results in more favorable prices and terms
from suppliers
Reduces impact of increasing union demands
Obtains access to lower cost production labor
Reduces inventory levels through elimination of one
complement of safety stocks
POTENTIAL DISTRIBUTION BENEFITS
Consolidation of warehouse facilities and/or equipment
Justifies acquisition of more automated warehouse
equipment
Permits sale of surplus facilities and/or equipment
Increased volume improves ability to negotiate
reductions in freight rates
Candidates distribution facilities closer to customers
POTENTIAL NEW PRODUCT DEVELOPMENT BENEFITS
Consolidation will Increase utilization of surplus capacity
Adds additional and/or complementary research skills
Adds additional research facilities and equipment
Permits sale of obsolete and/or redundant facilities
Reduction of redundant personnel
Obtains access to candidates secret technology
Reduces product development time

REF.

PREPARED BY

REVIEWED BY

41

REVISION

DATE

ENTITY

Form 4-04

POTENTIAL BENEFITS FROM ACQUISITION (Continued)


POTENTIAL BENEFIT

NO
IMPACT

NEGATIVE

SOMEWHAT
POSITIVE

VERY
POSITIVE

POTENTIAL HUMAN RESOURCE BENEFITS


Improve job security for employees
Opportunity to improve fringe benefit package
Enhance employees life style through relocation
Reduce vulnerability to increasing union demands

POTENTIAL PUBLIC RELATIONS BENEFITS


Enhance public image
Enhance investor image

OTHER POTENTIAL BENEFITS

REF.

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REVISION

DATE

SECTION

PAGE

ENTITY

Form 4-05

POTENTIAL IMPACT OF LOCATIONAL FACTORS ON A PROSPECTIVE INVESTMENT


LOCATIONAL FACTOR

NO
IMPACT

NEGATIVE

SOMEWHAT
POSITIVE

VERY
POSITIVE

Environment for production personnel


Environment for professional personnel
Proximity to customers
Proximity to suppliers
Availability of advanced communication services
Transportation facilities:
Proximity to expressways
Proximity to rail facilities
Proximity to air transportation facilities
Proximity to water transportation facilities
Ability to accommodate expansion:
Availability of existing facilities
Availability of vacant land for new construction
Local construction restrictions
Local construction costs
Local weather conditions
Local energy costs
Local environmental restrictions
Local government financial incentives
Tax concessions
Investment incentives
Revenue bond financing
Underwrite relocation costs
Underwrite training expenses

REF.

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DATE

SECTION

PAGE

ENTITY

Form 4-06

CHARACTERISTICS YOU MAY WISH TO AVOID


CHARACTERISTIC

DOES ENTITY HAVE


THIS
CHARACTERISTIC

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.

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SECTION

PAGE

ENTITY

Form 4-06

CHARACTERISTICS YOU MAY WISH TO AVOID (Continued)


CHARACTERISTIC

DOES ENTITY HAVE


THIS
CHARACTERISTIC

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.

OTHER CHARACTERISTICS TO BE AVOIDED


Past hazardous waste disposal practices.
Potentially costly litigation.

REF.

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REVISION

DATE

SECTION

PAGE

ENTITY

Form 4-07

WHY IS THE ENTITY AVAILABLE?


REASON

NOT
APPLICABLE

STATED
REASON(S)

OTHER
POSSIBLE
REASONS

OWNERS PERSONAL REASONS


Wishes to retire:
Has no heirs to take over.
Employees are not financially able to fund the acquisition.
Wants to go fishing.
Has a health condition.
Tired of working long hours.
Wishes to get into less demanding activities.
Tired of the heavy responsibility.
Desire for liquidity:
To get estate in order.
To invest in another activity.
Offered a more attractive opportunity.
Involved in a divorce settlement.

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

WHY IS THE ENTITY AVAILABLE? (Continued)


REASON

NOT
APPLICABLE

STATED
REASON(S)

OTHER
POSSIBLE
REASONS

BUSINESS REASONS (Continued)


Dispute between partners or controlling shareholders.
Expectation that the current selling price is potentially greater
than can be anticipated in the future.
Poor market conditions for raising needed capital infusion.
Deteriorating revenue and/or earnings trend.
Unsettled market for equity offering.
Potential loss of control to obtain required funds.
High interest cost associated with debt offering.
Severe restrictions imposed by potential lenders.
Anticipated benefits from being associated with a stronger, more
diversified, firm.
To avoid having to file for bankruptcy.
To avoid an unfriendly takeover.
OTHER REASONS

EXPERIENCE TO DATE IN SELLING THIS ENTITY

Is it common knowledge that this entity is available?

[ ] Yes

[ ] No.

How long has the entity been on the market? __________ months.
What other companies are known to have looked at this entity? __________________________________

Is the entity known to have received any firm offers?

[ ] Yes

[ ] No.

If so, from whom? ______________________________________________________________________

REF.

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PAGE

ENTITY

Form 4-08

COMPARISON WITH OTHER POTENTIAL INVESTMENT/ACQUISITION CANDIDATES


WHAT OTHER ENTITIES MEET MOST OF THE SAME INVESTMENT/ACQUISITION CRITERIA?

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.

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48

REVISION

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PAGE

DUE DILIGENCE HANDBOOK

5-00
SECTION 5

CAPITALIZATION AND OWNERSHIP


CONTENTS
SUBJECT

TEXT

FORM

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Summary Of Capitalization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Form 5-01

Capitalization - Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

Form 5-02

Common Stock - Miscellaneous Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Form 5-03

Common Stock - Dividend Record . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Form 5-04

Common Stock - Price And Trading Volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

Form 5-05

Common Stock - Holders Of More Than Four Percent Of Shares. . . . . . . . . . . . . . . . . . 55

Form 5-06

Capitalization - Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

Form 5-07

Preferred Stock Dividend Record . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

Form 5-08

Capitalization - Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

Form 5-09

Bond Yields And Major Bond Holders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

Form 5-10

49

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DUE DILIGENCE HANDBOOK

5-01
SECTION 5

CAPITALIZATION AND OWNERSHIP


Introduction
This section, when completed, will describe the elements of the entitys capital structure and the ownership
of the securities that are an integral part of this structure.
Summary Of Capitalization - Form 5-01
Form 5-01 will provide an overview of the entitys capital structure. Additional details, related to the longterm debt and equity components, are described in Sections 22 and 23 of this Handbook.
Before launching into a discussion of the individual elements of the capital structure, it is important to
review the major obligations that are included in the entitys long term debt.

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

DUE DILIGENCE HANDBOOK


Summary Of Capitalization - Form - 5-01 (Continued)
WHAT TO LOOK FOR (Continued)
Preferred Stock Coupon Rate
In most cases preferred stock is issued by companies that have fairly consistent and predictable
earnings. Consequently, coupon rates (equivalent to the interest rates on bonds) are usually on
the low side.
However, if they appear out of line on the high side, they should receive the same treatment as
high interest debt obligations. This is particularly true if they have a call feature.

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

DUE DILIGENCE HANDBOOK

5-03

Common Stock - Miscellaneous Information - Form 5-03


It is often assumed that common stock is common stock. That is, all common stock issued by a company
has virtually the same features. Not so! Form 5-03 identifies some of the major differences that can exist.
Theoretically the existence or nonexistence of many of these features should impact the markets evaluation of
the shares. As a practical matter most shareholders do not know whether their shares carry or dont carry these
provisions. A surprisingly high percentage of shareholders do not appreciate the significance of these factors.
These features can, however, become very important in an acquisition situation.
WHAT TO LOOK FOR
In a potential acquisition situation the percentage of shareholders that is required to approve
such an action is of obvious importance.
If shareholders have appraisal rights, this feature can result in an expensive and time
consuming valuation.
Restrictions on transferability, or using the shares as collateral, can also present problems.
A thorough review of the Security And Exchange Commissions mandated Registration
Statement(s) by a qualified corporate attorney is highly recommended.

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

DUE DILIGENCE HANDBOOK


Common Stock - Dividend Record - Form 5-04 (Continued)
WHAT TO LOOK FOR (Continued)
Stock Dividends
The bottom chart on Form 5-04 requests information on stock dividends. The issuance of a stock
dividend may reflect a temporary cash shortage. The firm may not have sufficient cash to pay a
cash dividend - yet wishes to maintain a record of uninterrupted dividends.
It is important, however, to gather the facts before concluding that a stock divided this is a negative event. Rather than pay a cash dividend, management may have rightly concluded that it
was more opportune to use the funds elsewhere - for example, to paydown high interest debt,
to upgrade its facilities or to make an acquisition.

Common Stock - Price And Trading Volume - Form 5-05


Form 5-05 provides for recording the high and low prices of the entitys common stock by quarter over the
last five years, the annual price/earnings ratio and the trading volume in number of shares and average
annual turnover.
WHAT TO LOOK FOR
Price Range
The per share price generally reflects investors expectations with respect to future earnings per
share. Consequently, the more volatile the expectations the greater the spread between the high
and low price range. Therefore, the lower the spread the better.
If there have been changes in the number of shares outstanding due to splits or reverse splits,
it is important that the appropriate adjustments be made prior to being recorded here.
The price per share has no significance for comparative purposes since firms have varying
numbers of shares outstanding.
Price/Earnings Ratio
The price/earnings ratio, on the other hand, has significance for comparative purposes. The
investors view of the quality of the earnings (i.e.: stability, accounting conservatism, etc.) and
the companys growth potential are the major determinants of the multiplier the investment
community will assign to the firms earnings, regardless of the number of shares.
Trading Volume And Turnover
As is the case with the per share price, the absolute value of the trading volume has little significance. However, the turnover in the shares, as a percentage of the total shares outstanding,
is indicative of the market action.
An important trend to look for in a potential acquisition situation is the near-term activity in the
entitys shares. An abnormally high turnover may indicate that one or more other companies have
designs on the entity. It may also indicate that the word has gotten out that someone is considering acquiring the entity - and they are hoping to benefit from the increasing stock price that often
accompanies such a transaction.

54

DUE DILIGENCE HANDBOOK

5-05

Common Stock - Major Shareholders - Form 5-06


Form 5-06 provides for the listing of all shareholders who own more than four percent of the entitys
common shares.
The form also provides for the identification of any relationships, either personal or business, that suggest that
any of the individually identified shareholders may vote their shares as a group.
WHAT TO LOOK FOR
Who Is In Control
Control of a corporation will generally rest with the shareholders who appear on this list.
This will be particularly true in the case of a potential acquisition of a publicly held corporation.
Most by-laws require that a sale or merger of the company must be approved by a majority of
the shareholders. In such cases the Board Of Directors may recommend approval or disapproval
but cannot consummate the transaction without the required shareholder acceptance.
Potential Alliances
Although an individual shareholder on this list may not appear to be in a controlling position,
they may be allied with other shareholders so as to represent a controlling force. Therefore, it
is important to identify such alliances and their combined shareholdings.

Preferred Stock - Forms 5-07 And 5-08


In the event the entity has issued preferred stock, the characteristics of the issue (or issues) should be entered
in Form 5-07. The dividend record on these securities should be entered in Form 5-08.
The periodic dividend payments on this type of security generally represent a fixed charge. Therefore, they
are frequently issued by firms whose future earnings are fairly predictable, e.g.: public utilities.
Where they are issued by firms whose earnings are less predictable, they usually represent a relatively small
portion of the total capitalization.
WHAT TO LOOK FOR
Dividend Payments
In the event the dividend payments represent a significant portion of an entitys earnings or
cash flow, consideration should be given to calling the shares at an early date. The existence
of specified call and/or conversion dates in the Registration Statement does not preclude the
company from making an offer to repurchase and/or exchange these securities at any time as
part of a refinancing package.
Dividend Payout
Most preferred stocks have a fixed dividend. However, some participating or income preferred stocks have been issued.
Dividend Yield
As noted in the comments on common stock, investors looking for current income pay particular attention to the yield represented by dividends.

55

5-06

DUE DILIGENCE HANDBOOK


Bonds - Forms 5-09 And 5-10

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

Less Current Portion


Total Long-Term Debt

PREFERRED STOCK

COMMON STOCK

ADDITIONAL SHAREHOLDERS EQUITY


Additional Paid-In Capital

Total Shareholders Equity

Total Capital (Long-Term Debt + Shareholders Equity)

Retained Earnings
Adjustments (Currency translation, pension funds, etc.)
Treasury Stock At Cost

Notes: (1) As of _________________ . (2) As of _________________ , [ ] Audited [ ] Unaudited.

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Form 5-02

CAPITALIZATION - COMMON STOCK


DESCRIPTION

SINGLE CLASS
OR CLASS A

CLASS B

NOTES

NUMBER OF SHARES AND SHAREHOLDERS


Currently Outstanding
Reserved For Stock Option/Bonus Plans
Reserved For Stock Purchase Plans
Reserved For Employee Stock Ownership Plan
Reserved For Conversion Of Warrants
Reserved For Conversion Of Preferred Stock
Reserved For Conversion Of Bonds
Reserved For Other Purposes
Total Outstanding And Reserved

Treasury Stock

Total Currently Authorized

Number Of Restricted Shares

Number Of Shareholders

LISTING INFORMATION
Exchange Where Listed
Stock Symbol
Lead Underwriter(s)

NOTES

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ENTITY

Form 5-03

COMMON STOCK - MISCELLANEOUS INFORMATION


PAR VALUE
Par Value - Dollars/Share

SHAREHOLDER RIGHTS
Shareholders meeting notice period.

Days

Percent of shareholders required to approve sale or merger.

Do shareholders have preemptive rights?


Do shareholders have liquidation preference?
Do shareholders have dividend preference?
Do dissenting shareholders have appraisal rights?
Is there cumulative voting for directors?
Are directors terms staggered?

RECENT COMMON STOCK OFFERINGS


ITEM

MOST RECENT

NEXT MOST RECENT

THIRD 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 on transferability? [ ] Yes [ ] No If so, 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:

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ENTITY

Form 5-04

COMMON STOCK - DIVIDEND RECORD


DIVIDEND RECORD - DOLLARS PER SHARE
PERIOD
First Qtr.

20

20

20

20

20

Second Qtr.
Third Qtr.
Fourth Qtr.
Year

DIVIDEND PAYOUT
YEAR

20

Dividends Per Share

20

20

20

20

Earnings Per Share


Dividend Payout

CURRENT YIELD (1)


Indicated Annual Dividend Per Share

Price Per Share

Indicated Yield

Note: (1) As of ___________________ .

STOCK DIVIDENDS
Has the Company issued stock dividends during the last five years? [ ] Yes [ ] No
If so, please provide the details.

REF.

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ENTITY

Form 5-05

COMMON STOCK - PRICE AND TRADING VOLUME


PERIOD

20

20

20

20

20

PRICE - HIGH/LOW lN DOLLARS PER SHARE


First Qtr.

Second Qtr.

Third Qtr.

Fourth Qtr.

: 1

: 1

AVERAGE ANNUAL PRICE / EARNINGS RATIO


Annual Ratio

: 1

: 1

: 1

TRADING VOLUME - NUMBER OF SHARES


First Qtr.
Second Qtr.
Third Qtr.
Fourth Qtr.
Year

AVERAGE ANNUAL TRADING TURNOVER AS A PERCENT OF TOTAL SHARES OUTSTANDING


Annual Turnover

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

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PAGE

ENTITY

Form 5-06

COMMON STOCK - HOLDERS OF MORE THAN FOUR PERCENT OF SHARES


SHAREHOLDER

SHARES
HELD
(000)

PERCENT OF
TOTAL

SHAREHOLDER

SHARES
HELD
(000)

PERCENT OF
TOTAL

(As Of ___________________ )
%

Total Shares Owned By Above Shareholders (2)


Note: (1) Array in order of declining percentage ownership.
(2) Percentage based on total of ____________________ shares outstanding.

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

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62

REVISION

DATE

SECTION

PAGE

ENTITY

Form 5-07

CAPITALIZATION - PREFERRED STOCK


DESCRIPTION

ISSUE OF
_______________

ISSUE OF
_______________

DISTRIBUTION OF SHARES
Shares Outstanding
Number Of Shareholders
FEATURES
Par Value

Coupon rate

per share

per share
%

Are dividends current?


Are dividends subordinated?
If so, to what?
Are dividends cumulative?
Is there a sinking fund requirement?
Do these shares participate in earnings?
Do these shares currently have voting rights?
Will they have voting rights if dividends are in arrears?
Are these shares convertible into common stock?
Are there staggered conversion dates and prices?
What is the earliest conversion date?
What is the earliest conversion price?

per share

per share

per share

per share

Are these shares callable?


Are there staggered call dates?
What is the earliest call date?
What is the earliest call price?
Who were the lead underwriters?
LISTING INFORMATION
Public or private placement
Exchange where listed
Stock symbol

REF.

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REVISION

DATE

SECTION

PAGE

ENTITY

Form 5-08

PREFERRED STOCK - DIVIDEND RECORD


DIVIDEND RECORD - DOLLARS PER SHARE
PERIOD
First Qtr.

20

20

20

20

20

Second Qtr.
Third Qtr.
Fourth Qtr.
Year

DIVIDEND PAYOUT
YEAR

20

Dividends Per Share

20

20

20

20

Earnings Per Share


Dividend Payout

CURRENT DIVIDEND YIELD (1)


Indicated Annual Dividend Per Share

Price Per Share

Indicated Yield

Note: (1) As of ___________________ .

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

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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
%

Are payments current?


Are bonds secured or unsecured?
Are payments subordinated?
If so, to what?
Is there a sinking fund requirement?
Are there serial maturities?
Do these bonds participate in earnings?
Will bonds have voting rights if payments are in default?
Were warrants attached to these bonds?
If so, for how many shares?
When can they be exercised?
What is the exercise price?
Are these bonds convertible into common stock?
Are there staggered conversion dates and prices?
What is the earliest conversion date?
What is the earliest conversion price?
Are these bonds callable?
Are there staggered call dates and prices?
What is the earliest call date?
What is the earliest call price?
Who were the lead underwriters?
Public or private placement?

REF.

PREPARED BY

REVIEWED BY

65

REVISION

DATE

SECTION

PAGE

ENTITY

Form 5-10

BOND YIELDS
CURRENT YIELD (1)
ITEM

ISSUE

ISSUE

Annual Interest Payment Per Bond

Current Price Per Bond

Current Yield

Note: (1) As of ____________ .

MAJOR BOND HOLDERS


ISSUE ___________________________
NAME

BONDS
HELD

Totals

ISSUE ______________________________

PERCENT
OF TOTAL

NAME

BONDS
HELD

PERCENT
OF TOTAL

Totals

Note: Total bonds outstanding as of _____________: _____________ and ________ respectively.

REF.

PREPARED BY

REVIEWED BY

66

REVISION

DATE

SECTION

PAGE

DUE DILIGENCE HANDBOOK

6-00
SECTION 6

ORGANIZATION AND MANAGEMENT


CONTENTS
SUBJECT

TEXT

FORM

Board Of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

Form 6-01

Board Of Directors - Other Affiliations And Compensation . . . . . . . . . . . . . . . . . . . . . . 69

Form 6-02

Board Of Directors - Current And Prospective Security Holdings. . . . . . . . . . . . . . . . . . 69

Form 6-03

Corporate Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

Form 6-04

Management Style . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

Corporate Management Resumes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

Form 6-05

Recent Compensation History Of Corporate Management Personnel . . . . . . . . . . . . . . . 73

Form 6-06

Company Security Holdings Of Corporate Management Personnel . . . . . . . . . . . . . . . . 73

Form 6-07

Organization And Management Information Requests. . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Form 6-08

Board Of Directors Opinions Of Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Form 6-09

Board Members Apparent Position Regarding Potential Acquisition. . . . . . . . . . . . . . . . 73

Form 6-10

Overall Management Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Form 6-11

Assessment Of Individual Management Personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Form 6-12

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DUE DILIGENCE HANDBOOK

6-01
SECTION 6

ORGANIZATION AND MANAGEMENT


Board Of Directors - Forms 6-01 Through 6-03
There is increasing importance being placed on the governance of publicly held corporations. Consequently,
knowledge of the makeup of the board and the conduct of its activities is a paramount concern.
Form 6-01 provides for the listing of the members of the entitys Board Of Directors, their age, years served
as a director and their participation on the various board committees.
Form 6-02, when completed, will list the board members current affiliations, and Form 6-03 their current
positions in the entitys securities.
WHAT TO LOOK FOR
Age And Years As Director
It is desirable to have a fairly uniform distribution of age and years of service as a director. If a large
percentage of the board is reaching, or will reach, retirement age within a short span of time, the
company will lose the benefit of their collective experience.
At the other end of the age and service spectrum, it is important to have several younger board
members who will bring in fresh ideas. They will also serve as representatives of their generations
response to the entitys activities.
Board And Committee Membership
Government and investor pressures are greatly increasing the importance, and workload, of the
board of publicly owned companies. No longer will the board, or its committees, be a rubber
stamp for management proposals.
When appropriate, members of the due diligence team may wish to meet with the key committee
members in their areas of mutual expertise.
Other Affiliations
Government and investor pressures are also impacting the makeup of the boards of public companies. The trends are to separate the Chairman and Chief Executive roles, and to have a majority of
outside directors. Consequently, the quality and experience of the outside directors will take on
increasing importance.
Security Ownership
The conventional wisdom is that directors who have a stake in a company will do a better job for
the shareholders at large.
A conflicting viewpoint is that a shareholder/director may not be as objective as a truly independent director. Short term profitability may take preference over what are sometimes referred to as
social responsibilities.
Whichever side of the debate you are on, knowledge of the directors security positions are of interest.
Director Intentions In An Acquisition Situation
There may not be a role for outside directors in the post-acquisition organization, in which case the
desires or intentions of a prior director become moot.
If the acquiror plans to maintain the entity as a separate unit, it may be advantageous to retain some
members of the entitys prior board. The acquiror may also invite one or more of the acquired entitys board members to join its board.
In these latter cases, knowledge of the individual directors desires is important.

69

6-02

DUE DILIGENCE HANDBOOK


Corporate Organization - Form 6-04

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:

Someone to produce the product or service - an operations or production manager.


Someone to market the product - a sales or marketing manager.
Someone to provide the necessary funds and to keep score - a finance manager.
Someone to provide the personnel - a personnel or human resources manager.
Someone to keep the organization out of legal difficulties - a chief council.
In small companies this function is often performed by an outside attorney.
Depending on the nature and complexity of the business, the CEO may have one or more additional positions
reporting to him, e.g.:

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