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Burned by due-diligence failures, some companies install safeguards against merger surprises.
Roy Harris, CFO Magazine
July 1, 2004
For Lockheed Martin Corp., the path to acquiring Titan Corp. has taken some unexpected twists. A few months after agreeing to pay $2.4 billion in cash and stock for the San Diego-based defense contractor last September, Lockheed uncovered questions about possible improper overseas payments that Titan consultants may have made, leading the Justice Department to open an investigation. Then, in May, a Titan employee was identified as being present during the abuse of Iraqis at Abu Ghraib prison.
While the employee's activities in Iraq didn't stall the deal — Lockheed CFO Chris Kubasik told an analyst conference that they "were not significant to our strategic decision" to acquire Titan — the foreign-payments situation certainly did. Lockheed first slashed its offering price to $20 a share in cash only — a total reduction of $200 million — and made Titan's settlement with the government a condition of the closing. (After Titan and the government failed to settle by June 25, a deadline set by Lockheed and Titan, Lockheed reportedly terminated the deal.)
Interestingly, it wasn't during due diligence that Lockheed detected Titan's foreign-payments problems. It was during "part of the transition planning process" for Titan, according to a spokesman for Bethesda, Maryland-based Lockheed — a process "generally more detailed than that involved in presigning due diligence."
Indeed, as the Lockheed situation illustrates, merger "surprises" can occur well after a binding agreement has been signed. After getting through due diligence, "you hope the transition planning will be just mechanical, like learning how to get two phone systems to work together," says Alexander Pyle, an attorney with Boston-based law firm Foley Hoag LLP. "But sometimes in looking at those mechanical issues, other questions emerge."
Few of those questions end up being deal-breakers. Post-diligence breakups, in fact, are extremely rare, while Pyle estimates that as many as 20 percent of deals fall apart during due diligence. "Once the deal has been announced, both sides have a lot of incentive to make it work," he says. But the end of the official due-diligence period often doesn't ease the complications. Among the issues that can continue to create a minefield: taxes, stock allocations, employee benefits, manufacturing capabilities, and environmental liabilities. In addition, legal contracts with noncompete or other limiting covenants have the potential to — at the very least — delay the closing, increase costs, and reduce profits.
To hedge against late discoveries, some buyers place 5 percent to 10 percent of the price in escrow, to be held back if problems arise. Others include earnout payments in the deal, spreading both the postacquisition risks and the rewards among the selling parties. Still, the best protection, say experts, is to create a flexible due-diligence process that can be updated to reflect past mistakes. Then remain vigilant in the post-due-diligence phase. That's a time when "there's a feeling that the two sides are all on the same side, and there's a little more potential for people to admit things they might have been guarded about before," says Pyle.
How Do We Build This Thing?
Like many companies, Needham, Massachusetts-based Brooktrout Technology "uses three forms of diligence: business, legal, and financial due diligence," says CFO Bob Leahy. "As we get closer to actually doing the deal, we bring in our organizational heads. They ask different questions and help us uncover things that normal due diligence wouldn't uncover."
It hasn't always worked. In the mid-1990s, for example, when Brooktrout bought a small unit of a larger company, Leahy recalls, "we were given information in due diligence about how to build their products. But lo and behold, when we tried to make the stuff, it didn't match what we had been told."
Leahy figures that the target company hadn't kept its documentation up-to-date, and had been relying on subcontractors to build the products. "It took us a good six to nine months to sort through it," he says. There was no recourse against the seller; Brooktrout "just used our internal resources to handle it."
The error did, however, help improve the company's due-diligence style. "We now have people go in and look at the engineering documentation" when reviewing acquisition candidates. "The lesson learned? Just because someone says it is the way it is, don't believe it."
The advent of Section 404 of the Sarbanes-Oxley Act of 2002, with its mandatory documentation of internal controls, is giving companies a greater comfort level when acquiring a firm — even if the target is private. "If sellers feel that the questions we're asking are impugning them," says Sean Creamer, CFO of Baltimore-based Laureate Education Inc., "we can now explain that it's nothing personal." But Section 404 is no guarantee if, for example, potential problems occur beyond the reach of the disclosure requirements. Moreover, he says, in any deal, "you're getting what the seller is willing to show you."
To be fair, "sometimes the seller just isn't focused on a potential problem," says Pyle, citing the case of a noncompete clause that may exist in a joint venture. A classic case involves Viacom Inc., which in 1994 acquired Paramount Studios. At the time, Paramount was involved in a joint venture with Universal Studios to operate cable television's USA Networks, and in the venture agreement, Universal, Paramount, and their affiliates agreed not to compete against USA. But Viacom also owned Viacom International, a unit that operated several cable channels competing with USA. Universal sued Viacom, citing breach of the noncompete, among other charges, and Viacom eventually divested itself of its interest in the venture.
"There are two lessons from this case," says Pyle. "In dealing with the clauses, it's important to be as clear as possible about the effect of the clause if the situation changes" between the parent and its venture interest. Meanwhile, the buyer should scrutinize joint ventures that otherwise seem harmless. "Don't assume you know what these provisions are going to mean and how they'll be applied," he suggests.
Haunted by the Arcane
For Keane Inc. CFO and senior vice president of finance John Leahy (no relation to Brooktrout's finance chief), "the sort of things we worry will come out of the woodwork are the latent tax issues." Eighteen months ago, he says, the Boston-based outsourcing-services concern "walked away from a deal solely because there were some pretty aggressive decisions" that were excluded from the target's disclosures. The extra tax-related due diligence saved Keane, says its CFO.
To guard against such merger surprises, Keane is among a growing number of companies designing its own online tools for helping managers with "the complete cycle of M&A," says Leahy. Keane developed its tool on its Lotus Notes system, where it leads acquisition team members from preliminary evaluation and negotiation through integration and postdeal review, presenting staffers with sample documentation through a tool kit and offering models of various deal stages.
"We're always refining it for new lessons learned," says Leahy. For one thing, the tool now instructs Keane's managers on revenue-recognition techniques — a lesson learned from an experience five years ago. "We were acquiring a private company in deep distress," recalls Leahy, and after due diligence was completed and the deal was closed, "we found out that they had prematurely booked some revenue on a sizable project. Although our people had taken a look at it and understood the technology, it wasn't until we took over that we realized the project wasn't as far along as had been presented." The project's profits suffered until the problems with the acquisition were corrected.
Creamer of Laureate, which has M&A guidelines similar to Keane's, says another key to success is to make "the company due-diligence checklist a living, breathing document. We try to learn from our mistakes, and from others that we read about."
Still, says John Leahy, the motto in any deal is to prepare for the unexpected. "It's absolutely the case that these things can be missed in due diligence. You're often looking at accounting and more basic things, and it's the more arcane items that can come back to haunt you."
Roy Harris is senior editor of CFO.